Vidya Mahambare: Monetary transmission to get more effective

Till 2005-06, the interest rate pass-through from policy rates to market rates was incomplete, but this trend began reversing from 2006-07 itself.

The RBI's forthcoming credit policy announcement (scheduled for July 31) is eagerly awaited given the current scenario of rising interest rates and a slowdown in the growth of industrial production. This article analyses the impact of previous rounds of monetary tightening by the RBI on market interest rates and the distribution of credit.

The RBI provides funds to the banking sector via repos which are essentially short-term loans. The rate charged by commercial banks on their loans should exceed the repo rate by a margin to cover transaction costs and default risk.

When the repo rate is increased these margins are maintained so that banks' retail rates change approximately in conjunction with the repo rates. As a result credit growth is expected to slow down which in turn affects the overall level of expenditure and prices in the economy. However, the speed with which policy achieves its objective(s) depends on how quickly policy actions are translated into changes in market interest rates. So how well does the monetary transmission mechanism work in India?

The current phase of monetary policy tightening that began in September 2004 has seen the reverse repo rate rise six times from 4.5 to 6 per cent, the repo rate seven times from 6 to 7.75 per cent and CRR five times from 4.5 to 6.5 per cent. However, it appears that the RBI's monetary policy tightening sequence had little or no impact on raising the banking sector's lending rates, at least up to March '06.

The weighted average interest rate of the banking sector as a whole (with weights being the share of credit at each interest rate range in total credit) in fact went down from 11.2 per cent in March 2004 to 9.3 per cent in March 2006 (fig 1). Moreover, if the average cost has come down during this period, the marginal cost (the rate at which the incremental credit is granted) must have fallen even more steeply.

There has been a marked shift in the pattern of credit availed at different interest rates between March '02 to March '06. Whereas only 3.4 per cent of total credit outstanding was granted at less than 10 per cent interest rate in March '02 (fig 2), more than a quarter of all credit outstanding (25.7 per cent) was granted below 10 per cent in March '06. In contrast, the share of credit granted above 16 per cent dropped significantly in 2006. Over the same five-year horizon the share of credit to individuals went up from 12 per cent to nearly 24 per cent while the share of credit to the public sector fell. How did the average interest rates that banks charge fall so significantly during these five years in spite of the RBI's persistent effort at tightening liquidity? The answer lies in the changing pattern of industry-wise credit.

In recent years commercial banks have increasingly started to explore new avenues for lending. During the five-year period from March '02 to March '06 the share of credit disbursed as personal loans has seen the highest growth "" the share of credit outstanding to personal loans has doubled to 20.7 per cent, albeit from a low base.

Moreover, the personal loan segment (especially loans to the housing sector) availed credit at relatively low interest rates. As of March '06 the entire housing credit outstanding was below the interest rate of 13 per cent. Furthermore, a large majority "" 83 per cent "" of it was between the interest rate range of 6-10 per cent (fig 3). In contrast, back in March '02, nearly 22 per cent of housing loan outstanding was at the interest rates of 13 per cent and above. A good deal of housing credit is classified as priority sector lending which is disbursed at a relatively low rate.

It is this change in the pattern of credit that has pulled down the average of cost of credit over this period. In sum, sluggish credit off-take by traditional customers such as industry combined with ample liquidity (due to capital inflows) with little dependence on the RBI refinancing allowed commercial banks to shift their focus towards retails loans to maintain their profit margins.

Excess liquidity also made the use of repo window by the RBI redundant. Since housing finance traditionally has been characterised by low non-performing assets (NPAs) and relatively high risk-adjusted returns, the move turned out to be profitable.

The above evidence suggests that the interest rate pass-through from policy rates to market rates was incomplete until 2005-06. This, in turn, restricts the RBI's ability to stabilise the economy and rein in inflationary expectations. The good news is that to some extent this trend has began to reverse during 2006-07 with commercial banks raising their lending rates more quickly in response to an increase in repo/reverse repo rates.

In fact, during the last fifteen months the country's largest private sector bank and a leader in the home loans market, ICICI Bank raised floating home loan rate by 3 percentage points to 12 per cent. HDFC raised its rate by 2 percentage points to 11.25 per cent.

Even the SBI, traditionally the least aggressive in terms of raising rates has raised its floating rate significantly during the last fiscal. As a result, in recent months credit growth has slowed down which in turn will affect output and prices going forward. We are, therefore, likely to see the conventional transmission mechanism becoming somewhat stronger during the coming months.

The author is an economist with CRISIL. The views are personal