What’s the issue?
1. By cutting the repo rate, the RBI has been signaling the banking system to reduce their lending rates.
2. This process of repo rate cuts leading to interest rate cuts across the banking system is called “monetary policy transmission”.
3. Since February, RBI has been cutting its interest rates. But, bank lending rates for new loans have not fallen much, rather existing loans have actually gone up.
Why does RBI want lower interest rates?
1. India’s economic growth has rapidly decelerated with GDP growth projections coming down to 5.8%-6.0%.
2. This is due to two key problems in the economy-
a. People are not consuming at a high enough rate.
b. Businesses are not investing in existing or new facilities due to unsold inventories.
3. Reduced lending rates would also bring down the deposit rates which will incentivize people to save less and spend more.
4. Also, with low-interest rates businesses are likely to borrow new loans for investment.
5. So, the government has also cut corporate tax rates, which will boost the corporate sector’s profitability and investment.
Which factors prevent interest rates reduction?
1. Deposits constitute 80% from which banks lend and borrowings under the repo is a fraction of it.
2. So even sharply reducing the repo rate doesn’t change the overall cost of funds and reducing lending rates is not feasible for banks.
3. Unless banks reduce their deposit rates, they will not be able to reduce their lending rates.
4. Also, if a bank reduces its deposit rates, depositors would shift to a rival bank or to small saving instruments such as public provident fund, Sukanya Samriddhi Yojana etc. that pay higher interest rates.
5. Moreover, 65% of total deposits are “term” deposits with an average duration of upto two years to get repriced, banks can’t reduce them immediately.
Where the challenge lies?
1. The banks cannot link their lending to the repo rate as repo doesn’t determine their cost of funds.
2. For a repo-linked regime to work, the whole banking system with both banks’ lending rates and deposit rates must be linked with repo.
3. But it would affect the interest rate on their savings account (1.10% less than now)
How better are developed countries?
1. The financial system is far more developed and diversified in developed countries.
2. Their banking system doesn’t have the burden of providing loans to everyone in the economy.
3. Most demands for big loans are fulfilled through the corporate bond market where the market determines the interest rates.
4. Moreover, depositors don’t get a fixed interest rate on their savings and a variable interest rate on their loans.
5. The overall borrowing by the public sector in developed countries is not so high to increase the interest rates in the economy as in India.
6. Also, the savers are more risk-averse in India and unwilling to invest in higher-risk instruments other than bank deposits.