Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 6 Monetary Transmission Mechanism

Monetary Transmission: The Indian Experience

With the initiation of financial sector reforms, monetary management in India has been increasingly relying on the use of indirect instruments like open market operations and fine-tuning of liquidity conditions through the Liquidity Adjustment Facility. As discussed in Module: 2, modulations in policy interest rates have emerged as a principal instrument of signalling monetary policy stance. This Section analyses movements in nominal and real interest rates. Policy efforts to impart greater flexibility to the interest rate structure are discussed and an attempt is made to estimate pass-through from policy rates to market rates. Finally, the dynamics of output and prices to monetary policy signals and the interaction between exchange rate and interest rate are empirically examined in an attempt to explore channels of monetary transmission in India.

Key monetary policy rates - the Bank Rate and the repo rate - have been reduced substantially since 1998 reflecting the countercyclical monetary policy stance. The Bank Rate was reduced from 11.0 per cent in January 1998 to 6.0 per cent by April 2003. The repo rate also witnessed a cut from 6.0 per cent in January 1999 to 4.5 per cent in August 2003 (before being raised to 4.75 percent in October 2004), notwithstanding an increase in the second half of 2000 (touching a peak of 15.0 per cent in August 2000 before falling to 8.0 per cent by December 2001). The reduction in key policy rates has been supplemented with cuts in cash reserve ratio from 10.5 per cent in January 1998 to 4.5 per cent by June 2003 (although subsequently increased to 5.0 per cent in September-October 2004). While the changes in policy rates were quickly mirrored in the money market rates as well as in Government bond yields, lending and deposits rates of banks, however, exhibited a degree of sluggishness.

The relative downward inflexibility in the commercial interest rate structure can be attributed to a number of factors:

• Average cost of deposits for major banks continues to be relatively high.

• A substantial portion of deposits is in the form of long-term deposits at fixed interest rates which reduced the flexibility available to banks to reduce interest rates in the shor t-run, without adversely affecting their return on assets.

• Relatively high interest rates on competing instruments of savings, viz., administered small saving instruments.

• Relatively high overhang of non-performing assets (NPAs), although these have been declining quite substantially in the last three years.

• In view of legal constraints and procedural bottlenecks in recovery of dues by banks, the risk-premium tends to be higher resulting in wider spread between deposit rates and lending rates.

• Large borrowing programme of the Government, over and above the SLR requirements, provides significant prospects for deployment of funds by banks in sovereign paper (RBI, 2003).

In order to overcome these rigidities and to provide more flexibility in the interest rate structure, the Reserve Bank has initiated a number of measures in the past 3-4 years. These include, inter alia, advising banks: to introduce flexible interest rate option for new deposits; to review their maximum spreads over PLR and reduce them wherever they are unreasonably high; to announce the maximum spread over PLR to the public along with the announcement of their PLR; and, to switch over to "all cost" concept for borrowers by explicitly declaring the various charges such as processing and service charges. To have a greater degree of transparency in regard to actual interest rates for depositors as well as borrowers, the Reserve Bank has put out information on its website on (a) deposit rates for various maturities and effective annualised return to the depositors and (b) maximum and minimum interest rates charged to their borrowers.

To further enhance the transparency and to reduce the complexity involved in pricing of loans as also to ensure that the PLR truly reflects the actual costs, the Reserve Bank in its Annual Monetary Policy Statement (April 2003) advised banks to announce a benchmark PLR (BPLR) taking into account the following factors:

1. actual cost of funds,

2. operating expenses and

3. a minimum margin to cover regulatory requirement of provisioning/capital charge and profit margin.

These initiatives were helpful and the public sector banks reduced their interest rates by 25 to 100 basis points in January 2004 while announcing their BPLR.

More generally, the various policy initiatives of the Reserve Bank over the last 3-4 years have been able to impart a greater degree of flexibility to the interest rate structure, leading to a softening of interest rates on both deposits and loans. Illustratively, more than one-half of outstanding time deposits of scheduled commercial banks at end-March 2003 were contracted at interest rates of upto eight per cent per annum. In contrast, this proportion was as low as 11 per cent at end-March 1996. Correspondingly, the proportion of time deposits in the high interest bracket (11 per cent per annum and above) has seen a significant decline from 67 per cent at end-March 1996 to less than eight per cent at end-March 2003. Based on these data, weighted average interest rate on time deposits of scheduled commercial banks is estimated to have declined from around 11.6 per cent at end-March 1996 to around eight per cent at end-March 2003.

A similar softening in lending rates is visible from an analysis of the outstanding loans. At present, more than one-half of the outstanding loans has been lent at interest rates of 14 per cent per annum or below. In contrast, this proportion was as low as 17 per cent at end-March 1995 and 36 per cent at end-March 2000. Correspondingly, the proportion of outstanding loans at interest rates of more than 16 per cent has declined from almost two-thirds of total outstanding loans at end-March 1997 to less than 15 per cent by end-March 2003. Based on these data, the weighted average lending rate is estimated to have declined from its recent peak of 17.1 per cent in March 1997 to 13.6 per cent in March 2003 and is, in fact, at its lowest level in the last two decades.

Between June 2002 and June 2004, the lending rates of the banks (the rates at which at least 60 per cent of lending takes place) have declined further. The sharpest decline is witnessed in the case of private sector banks. Similarly, interest rates on deposits have seen a further softening since March 2001. In particular, deposits above one-year maturity have exhibited a significant reduction which suggests an enhanced flexibility to the banks in pricing their loans in the future. Empirical evidence confirms that pass-through in India is less than unity although there are signs of an increase in pass-through over time (Box VII.4).