Transmission travails

Time to free interest rates for small savings, provident funds

The Reserve Bank of India has been highlighting the problems with the economy's monetary transmission mechanism for some time now. In the most recent policy statement, the RBI Governor, Raghuram Rajan, emphasised the fact that, while the repo rate had been reduced by a cumulative 75 basis points, the average bank lending rate had come down only by 30 basis points. Since then, some major banks have brought down their base lending rates a little more. Meanwhile, the RBI has followed through on its intention to change the formula for determining the base rate, by shifting it from its dependence on the banks' average cost of funds to the more economically efficient marginal cost. This means that banks' pricing of new loans will depend on the cost of their most recent fund mobilisation. If repo rate changes impact this number, then base lending rates will also more closely track policy rates, leading to better transmission. Of course, the guidelines for this are still in draft stages, so a resolution may take some time. Meanwhile, the question must be asked: is this in and of itself a potential solution to the transmission problem?

The answer must be in the negative. There are other factors that influence the transmission mechanism and at least two of them are hindrances to efficiency in the current situation. First, there is the rather frustrating legacy of administered interest rates, the most prominent of which are the rates on small savings and provident funds. Despite strong recommendations by committees headed by Y V Reddy and Shyamala Gopinath that the small savings rate be linked to market rates, the government has been reluctant to do so. Similarly, the return on provident funds is decided annually by a process that can only be described as political. These two rigidities have a clear impact on portfolio decisions by households and their failure to adjust to market conditions necessarily impedes monetary transmission. Second, there is the impact of "pre-emptions"; the Statutory Liquidity Ratio (SLR), which requires banks to hold a certain proportion of their liabilities as government securities; the offset to this mandate is an exemption from mark-to-market requirements. This effectively kills the incentive for banks to actively trade government securities, a factor that has constrained the development of an active market. In turn, the absence of a meaningful risk-free yield curve has deterred the emergence of an active market for corporate bonds. The Urjit Patel Committee had, in fact, indicated that the development of bond markets would be a critical prerequisite for an effective inflation targeting framework.

Unfortunately, neither issue appears to have been given adequate priority in the debate on financial sector reforms. On the first, the last time the interest rate on small savings was changed was in 2002. On the second, notwithstanding his commitment to doing away with pre-emptions in his inaugural speech two years ago, Dr Rajan has moved quite slowly. Given the persistence of these rigidities, it might be wishful thinking to expect a change in the base rate formula to immediately improve transmission efficiency. Instead, the RBI needs to take a holistic view of all the factors that might hinder transmission and act in concert with the government to deal with them.