RBI may need to inject further ‘2lakh crore to let rates transmit
That the Reserve Bank of India (RBI) may have to inject another ₹2 lakh crores into the system in order to have an effective transmission of interest rates is a symptom of a larger problem in the monetary policy framework of India, which pertains to the gap which arises sometimes between what policymakers think they are achieving and what they actually achieve. A cut in interest rates, for example, aims to lower borrowing costs and hence impact investment, consumption, and GDP in a favorable manner. But sometimes, if liquidity in the economy is tight, this benefit may not reach all borrowing firms.
To grasp this problem in detail, it is important to have a basic understanding of rate transmission. Rate transmission can be described as a mechanism through which a change in the policy interest rates, particularly the repo rate, of the Reserve Bank of India gets translated into a subsequent change in the lending and deposit rates of commercial banks. Normally, when the Reserve Bank of India lowers the repo rate, it is expected to see a dropdown in the lending rate of banks, thus making borrowing cheaper for industries and people.
Liquidity constraint in the banking sector is one of the major factors leading to poor rate transmission. Banks will not be able to lower their lending rates, even if the RBI reduces the policy interest rate, if they face difficulties in attracting deposits or if there is a liquidity constraint in the overall banking sector. Banks are largely dependent on deposits for lending, and if deposit growth slows down or if competition for deposits heats up, banks have no option but to maintain high interest rates in order to attract deposits.
This is where liquidity injection by the RBI steps into the picture. Liquidity injection can be explained as a situation where a central bank, in this case, the RBI, infuses money into the banking sector using different tools such as Open Market Operations, Long Term Ops, Variable Rates Repos, and/or bond purchases. When liquidity is injected into the economy by the RBI, this ensures that banks have access to money at a reduced cost, making them less reliant on expensive deposits.
The implication of another ₹2 lakh crore being required shows that despite this liquidity infusion, a problem may not be alleviated. Several reasons are attributed to this. One such important reason is credit demand. With a revival in economic activity, demands for credit in the corporate, MSME, and retail sectors see a substantial increase. Although an increase in credit is a good indicator in an economy, it simultaneously acts as a challenge in terms of banks’ funding bases, in case deposits do not grow at a proportional pace.
Credit growth in excess of deposit growth in recent years in the Indian economy is leading to a funding problem for banks in the country. As banks in such a situation increase their lending with less than equal proportions of deposits, they have to resort to either wholesale borrowing or borrow from other banks, thus sometimes incurring higher and fluctuating costs. Thus, they will not be able to decrease their lending interest rates despite a cut in the policy rate by the RBI.Injecting ₹2 lakh crores in the economy will bridge this gap.
The other major factor because of which rate transmission is not very strong is the impact of former high interest rates. Banks have deposits parked with them, which weredfat higher interest rates in former tightening cycles. As deposits are normally for fixed terms, banks are not in a position to immediately lower their cost of funds when interest rates cut by the RBI. Hence, banks’ lending rates become sticky downwards. Liquidity provided by the RBI can counter this problem by providing lower-cost money to banks, which can help banks to lower their lending rates.
The external environment is another factor which plays an important role. The global interest rates, especially in advanced economies, have a major impact on capital inflows in emerging economies such as India. A high global interest rate level signals caution to the RBI if it thinks of injecting excess liquidity into the economy or lowering interest rates, which can lead to a capital outflow. But in a situation where a boost in domestic economy is desired and inflation is in control, a targeted liquidity injection will be a preferable option.
As far as the Reserve Bank of India is concerned, liquidity regulation is a delicate tightrope walk. Going for less liquidity can be counterproductive since it can strangle credit and hamper interest rate transmission, but excess liquidity can cause price inflations and asset bubbles. Here, the proposal to infuse ₹2 lakh crore liquidity appears to have a measured impact, which is neither too much nor too less.
The effects of efficient rate transmission are more relevant in the case of small and medium enterprises and retail borrowers. Small and medium enterprises are very sensitive to interest rates, and a small cut in interest rates will have a major effect on their cash flow and profitability. A reduction in lending rates for housing, car, and personal loans will increase consumption expenditure, which is a major contributor to the GDP of India.
Improving transmission will benefit the non-financial corporate sector, especially capital-intensive sectors such as infrastructure, manufacturing, and renewable energy. With lower borrowing costs, projects will become more feasible, and new investments will be encouraged. This is in line with the overall developmental plans for India in terms of developing infrastructure, improving manufacturing, and achieving ‘swavalamban.’
The bond market is also-sensitive to a successful liquidity infusion. With a liquidity infusion by the RBI, bond yields in both government and corporate sectors soften, which leads to a reduction in borrowing costs in both government and non-government sectors. A ₹2 lakh crore infusion will help stabilize bond yields, especially when the government borrows heavily.
Banking Sector: Excess liquidity in the banking sector will improve financial stability. Liquidity in money markets will ease pressure, and interbank borrowing costs will come down. Some banks will have better balance sheets, and credit risk can be managed effectively. Liquidity in banks will help banks with poor credit performance. Liquidity in banks will make banks less vulnerable when asset quality issues creep in.
One could suggest that by injecting liquidity on a constant basis, moral hazard can arise, which can lead to banks being overly reliant on support from the central bank instead of working on improving their deposit base mobilization and efficiency. But it can be safely assumed that a normal liquidity strategy adopted by the RBI is time-bound, selective, and conditional in nature, which will not make banks reliant on easy money. Inflation remains a major consideration in liquidity decisions. A situation where pressure is developing in the inflation front will imply that surplus liquidity in the economy can aggravate this situation with a resulting jump in demand over supply. Thus, this liquidity infusion by the RBI will be strongly linked to developments in the inflation front and food prices. A liquidity infusion of ₹2 lakh crores will thus have a focused strategy with not aims to reverse inflation. Secondly, financial inclusion and credit accessibility can be considered. In situations where rate transmission is weak, monetary policies towards lower interest rates largely benefit companies or better borrowers. However, with better liquidity and rate transmission, lower interest rates can benefit a broader segment of society in terms of new borrowers, small businesses in rural areas, or self-employed people. Looking into history, it can be observed that a combination of liquidity and interest rate decisions in the Indian economy have always shown that a focus solely on interest rate decisions without a corresponding focus on liquidity can impede the transmission of interest rate decisions. On the other hand, an effective focus on liquidity can lead to quicker and better transmission. The current debate over injecting liquidity of ₹2 lakh crore stands in this context. Conclusion
In conclusion, the implication that an additional infusion of ₹2 lakh crores may be needed by the RBI in order to allow interest rate transmission effectively throws light on the realities associated with interest rate policies in countries with economies as large, diverse, and dynamic as that of India. While rate reductions are important, it is important to achieve them in a manner that is aided by adequate liquidity, sound banking balance sheets, controlled and manageable inflation expectations, and a supportive global setting.
