What monetary transmission means: Abheek Barua

Reducing policy rates is not enough. The key is to ensure banks lend to credit- constrained borrowers

If there is a single blot on the otherwise unblemished track record of Reserve Bank of India ( RBI) Governor Raghuram Rajan, it would be his inability to ensure smooth “ transmission” of RBI’s policy signals to actual lending rates in the economy. While the central bank has lowered the signal repo rate by one- and- a- half percentage points, banks have reduced lending rates by less. It is perhaps legitimate for the governor to claim that he is hardly to blame for this, that he has done his bit and the ball has always been in banks’ courts. However, the effectiveness of monetary policy is ultimately about RBI’s actions translating into reduced EMI’s on mortgages and car loans, lower credit card rates, cheaper working capital and so on. Thus, transmission of RBI policy is agauge of how well monetary policy as a whole has worked in stimulating the economy. If it hasn’t quite done the trick, the central bank must take some responsibility for it.

Mr Rajan’s predicament was partly because of the monetary policy regime that he inherited. Around 2010 when D Subbarao was at the helm, RBI decided to change the monetary regime it operated in. Previously, the central bank allowed episodes in which banks were short of liquidity ( thus, borrowing from RBI through its repo window) and those in which they were surplus ( parking surplus funds with RBI at the reverse repo rate). The new regime was one in which they there would be a “ permanent” or “ structural” liquidity deficit of roughly one per cent of banks’ deposits, ensuring that banks would always be net borrowers at the central banks refinance window.

This shift in regime, coupled with the fact that the actual liquidity deficit often exceeded the target, introduced an element of uncertainty about their fund position that kept bankers on edge. Thus, it wasn’t surprising that banks wanted to ensure that they had enough deposits to fall back on. Deposit rates remained sticky. Banks run on commercial principles and attempt to maximise the margin between lending and deposit rates. In the absence of significant deposit rate reductions, lending rates did not change much.

                                   Abheek Barua

Mr Rajan finally addressed this problem in the April 2016 monetary policy by reverting to the old regime, and committing to maintain aneutral liquidity regime. This meant plugging the “ structural” deficit by infusing liquidity both through bond purchases ( buying bonds from the market and offering cash in exchange) or by buying dollars in exchange for freshly minted rupees. Critics would claim that RBI could have done this much earlier to give the economy a helping hand instead of laying the blame on banks’ shoulders. A more charitable view is that a major systemic change of this sort takes time, especially with inflationary pressures ( traditionally associated with high liquidity) looming in the background.

Even if banks were to fall in line in this new regime, that might not be the end of RBI’s problems. A recent paper by Johannes Stroebel and three of his colleagues (‘ Do Banks Pass Through Credit Expansions? The Marginal Profitability of Consumer Lending During the Great Recession’, August 2015, New York University Working Paper) points out that transmission is likely to boost the economy only if banks pass on the benefits of monetary or credit expansion by the central bank (like a cut in the policy rate) to credit- constrained borrowers, those with ahigh marginal propensity to borrow. These borrowers, freed from their credit constraints are likely to spend more. Increasing the supply of credit to those who already have ample funds does not give the economy a cyclical boost. Trying to lend to borrowers who already have enough cash is somewhat pointless — if they wanted to spend more, they would have already done so.

Mr Stroebel and his colleagues examine the impact of a reduction in the cost of funds for 8.5 million credit card holders in the US between 2008 and 2014. They find that banks were least willing to increase credit limits for those who wanted to borrow the most, and most eager to lend to those who were not interested in borrowing at all. This apparently strange pattern has a simple explanation — the marginal propensity to borrow is inversely related to the risk- score (FICO scores) of borrowers. Credit constrained borrowers are the riskiest and while they provide a ready market for loans, high default rates actually erode banks’ profitability.

Mr Stroebel and his colleagues claim that this disconnect between the marginal propensity to borrow and the marginal propensity to lend of banks is why the attempt to expand credit, or more generally monetary policy, has not been effective in fighting the recession in the US that followed the great financial crisis. Their work does not have lessons only for the American credit card market or the US economy. The findings have implications for all credit markets, both retail and corporate. I would find it particularly relevant for India. With default rates and stressed loans already high in the system, banks would be perfectly justified (as a rational business decision) not to lend to those firms that are strapped for credit, desperate to borrow but likely to find it difficult to service loans. Going by RBI data, there has been a noticeable drop in credit disbursed to small and medium enterprises over the past few months. While some of this could be explained by the lack of demand for funds, banks’ reluctance to lend has also been a factor.

Monetary transmission in the sense of getting policy rate cuts to actually impact on the economy is not just about persuading banks to lower their benchmark lending rate in tandem with policy rates. They might just comply now that RBI is willing to keep liquidity neutral; whether they will actually lend to the ‘ right’ borrowers in the current economic environment is another story. Mr Stroebel’s paper shows that India will not be alone in finding out that monetary policy is somewhat weak in propping up a sagging economy. Fiscal policy, anyone?

Raghuram Rajan coy about second term as RBI Governor

New Delhi has not yet asked Raghuram Rajan whether he would like to pad up for a second innings at the Reserve Bank of India after his term ends on September 4. In the past one month, there has been endless speculation about the equations between the government and the RBI governor — whether Rajan would be given a cold shoulder, or offered another term, or invited to play a different role.

"That question, I can't answer. First I have to be asked, 'Do you want to continue?' Then, I can answer," said Rajan at the Shiv Nadar University on Saturday when ET asked him whether he would like a second term as the RBI boss. There is a widely shared perception in financial markets and banking circles that the Centre may find it difficult to refuse a second term to Rajan if he were keen on continuing. But as of now, the Chicago school economist — who in the past three years has positioned himself as an inflation warrior — is keeping options open.

"I love teaching. I will go back to academia once I am done with my work here," Rajan said in a meeting with the Shiv Nadar University's faculty. The governor was the chief guest at the second convocation of the university, which was founded in 2011. Even though corporate India and local markets have criticised Rajan's policy to keep interest rates high and liquidity tight, foreign portfolio managers, who have gained from high rates and a stable rupee, have been vocal admirers of Rajan.

Last week, Christopher Wood, equity strategist at brokerage and investment group CLSA, said the biggest risk to the Indian bond and currency market will be if the RBI governor is not given a second term. "He (Prime Minister Narendra Modi) must recognise the constructive role played by RBI under Rajan in both imposing a tighter NPL (non-performing loan) system on banks, carrying out a stress test on banks and putting pressure on them to go after defaulting creditors," Wood wrote in the widely circulated CLSA newsletter.

Before taking over as the RBI governor in September 2013, Rajan was the chief economic adviser in the ministry of finance. Prior to that, he was a professor of finance at the University of Chicago Booth School of Business and chief economist at the International Monetary Fund. "I have no problems with India's growth. It could be better. The best is yet to come," said Rajan.

Rajan also stressed the need to have research-oriented universities. "As a country, as we grow in stature, we have to contribute ideas. We are always protesting — this doesn't look good, that doesn't look good. We are always underprepared and that's why we shout." Back in the '50s, he pointed out, ideas and concepts such as Panchsheel emerged in India, but today "we are a shouting lot".



"If we contribute ideas based on facts, based on research, we could very quickly become leaders," he said. Addressing students at the convocation, Rajan said, "India is changing, in many ways for the better. You will be able to help shape our country, the world, and your place in it. Play to your strengths." Referring to the Shiv Nadar University, founded by billionaire tech czar Shiv Nadar, Rajan said, "I would like to see places like this flourish. Thoughtful philanthropy, as reflected in the founding of this school, can further help enhance society's acceptance of great wealth."

However, adding a word of caution, the RBI governor said, "We should make sure that unscrupulous schools do not prey on uninformed students, leaving them with high debt and useless degrees." Greater Noida, where Shiv Nadar University is located, is emerging as an educational hub with around 50 colleges attracting students from across the country.