Have the rate cuts been effective?

By Prakhar Misra

The effect of the monetary easing by the RBI over the past year has not transmitted through to the end consumer bringing into question the efficacy of monetary policy in India.

The Reserve Bank of India, over the past year, under the aegis of its Governor Raghuram Rajan has given quite a huge boost to the economy. It cut the policy rate to 6.75%, the lowest in four and a half years. However, in the largely intricate financial world, the result is not immediately perceivable as the banks haven’t passed on the benefits of the RBI measures to the end consumer.

Over the past year, the RBI has cut interest rates 4 times. The last cut was by 50 basis points, which is unprecedented, as until now, the RBI has been changing the interest rate by ‘baby steps’ (25 basis points). The below graph shows that at the beginning of the year interest rates were at 7.75% and have been dropped by a percentage point over the past year.

Repo rate in India since 2012

Repo rate in India since 2012

A cut in the interest rates should ideally translate to growth in the economy as the firms and corporations now have to borrow money at a lesser price and thus can use that money to invest in more physical capital and human capital – adding to the employment and organically, to the GDP. This reduces unemployment and increases wage rates as well. The low interest rate is an advantage to consumers also because they can borrow and spend money at a lower cost. This adds to the Indian GDP as it boosts sectors like the real-estate, consumer goods, etc.

The only disadvantage of a policy aimed at monetary easing is the fear of inflation. The RBI had set a target of maintaining inflation below 6% and they have done pretty well in this regard. Inflation was about 11% in 2012 and has fallen gradually to just above 4% this year, indicating that this is an opportune time to decrease interest rates and allow the economy to pace-up without the fear of rising inflation. After the GDP fell to 7% from 7.5% the previous quarter, there seems to be a need for such a rate cut to be in effect.

However, the problem lies in the fact that the RBI controls only the Policy rate(or the repo rate). This is also called the overnight borrowing rate which is the rate at which the banks either borrow from one another, or borrow from the RBI in order to maintain their balance sheets. So, the general perception is that if the borrowing of banks is made cheaper, then that should translate to the consumer as well and borrowing should be made cheaper for the end-user too. With this intention, the rate cut was implemented in the first place. But, it hasn’t gone down this way.

The base rates set by major banks, as of end November, is still above 9%. HDFC is at 9.35%, SBI and ICICI at 9.70% while Bank of Baroda and Canara Bank are at 9.90%.


One reason could be that banks, themselves, have not been borrowing enough from the RBI for this rate to actually affect them. The following graph shows that for most of July, August and September- banks have not borrowed a lot from the RBI.

Thus, it can be concluded that the policy rate cut may not affect the banks as much as one expects it would and that this outcome is not entirely surprising in that light.

Competitiveness among banks also doesn’t seem to push them towards reducing the base rates so as to gain a larger share of the pie. After the interest rate cut of half a percentage point in January this year, only 4 out of 47 banks had lowered their interest rates. So, no one seems to be in a hurry to act in this domain.

Rising Non Performing Assets (NPAs) may be yet another problem that the banks might want to mitigate, thus keeping rates high. The number of bad loans are close to 6% from 4.4% in March earlier this year. Infact, Minister of State for Finance, Jayant Sinha announced that NPAs were worth 2.67 lakh crore during March 2015 up from 2.16 lakh crore in March last year. The banks, obviously, would not want to aggravate this situation any further.

The number of investment instruments are also plenty. Thus, to combat the more preferred instruments like mutual funds for instance, which provide tax benefits- banks would want to keep their rates high so that people don’t move to other financial measures.

IMF, in a paper titled Effectiveness of Monetary Policy Transmission in India said that on an average it takes about 9 months to change deposit rate for customers and as much as 19 months to bring about a change in lending rates. In the report, it questions the efficacy of monetary policy for all developing countries but also states that “this hinders policy making by making it difficult to predict the effects of policy actions on the economy”.

As Crisil Research points out in a research “Lending rates show upward flexibility during monetary tightening but downward rigidity during easing. Between 2002 and 2004, while the policy rate declined by 200 basis points, lending rates dropped by just 90-100 basis points. Conversely, in 2011-12, when the policy rate rose by 170 basis points, lending rates surged 150 basis points.”

The effects of such move would show negatively for the rate of growth and its real impact on the Indian economy. But, the thing to watch out for is if the RBI has already taken this into account. As for what would happen next is anybody’s guess, as is always in the world of financial markets.

Prakhar Misra is a Chanakya Scholar at the Meghna Desai Academy of Economics and an alumnus of the Graduate Certificate in Public Policy Programme, 2015.