Apart from reviewing the PLR mechanism, the LAF facility also needs to be looked into again.
As last Tuesday’s policy statement acknowledges, the transmission of changes in the policy rates in the deposit and loan-pricing of commercial banks is not as effective as it should be. In recent months, policy rates have dropped much more than the fall in the deposit or lending rates of banks. In the US, in contrast, the correlation between the policy and prime rates is very strong.
In general, the greater the uncertainty in terms of the price or availability of money, the larger would be the cushion market participants (banks in this case) would structure into the interest rates. Is the operation of the liquidity adjustment facility (LAF) itself contributing to the uncertainty? For one thing, there are two policy rates (the Bank Rate itself has become irrelevant for most practical purposes), while most central banks have a single one — like, for example, the federal funds rate in the US which the Federal Reserve targets through open market operations. At one time, the gap between the two rates was as wide as 3 per cent; it has now come down to 1.5 per cent, but is still not insignificant. Often, the interbank or CBLO rates have ruled below or above the policy rates, defeating the very purpose of the corridor. Overall, there does seem to be a case for reviewing the operation of the LAF, also including the system of bidding by banks, which leads to uncertainty about the acceptance or otherwise of the bids. Incidentally, the policy itself has given, probably unwittingly, contrary signals: While both the administered rates have been dropped by a quarter per cent, the revision in the calculation of interest on savings bank account, which form a significant proportion of bank deposits, effectively means an increase in the rate!
| TRANSMISSION MECHANISM (decline in basis points, bps) | ||
| INDIA | ||
| Instrument | Mid-Sept 2008 | Early March 2009 |
| Repo Rate | 900 | 500 |
| Reverse Repo Rate | 600 | 350 |
| CRR | 900 | 500 |
| Oct 2008-April 2009 | Deposit rates | Lending rates |
| PSU banks | 125-250 | 125-225 |
| Private sector banks | 75-200 | 100-125 |
| Top 5 foreign banks | 100-200 | 0-100 |
| UNITED STATES | ||
| 30 April 2008 | 16 December 2008 | |
| Fed Funds Target Rate | 200 | 0-25 |
| WSJ Prime Rate | 500 | 325 |
| * A basis point is one- hundredth of one per cent | ||
The policy statement also gives various reasons advanced by bankers, which are coming in the way of a drop in the market rates for deposits and loans. Bankers have claimed that, under the current practice, in a rising rate scenario, depositors take premature encashment of an existing deposit, and re-deploy it at a higher rate; on the other hand, when rates are falling, the banks are stuck with the existing high rate deposits. There is a simple, and logical, solution to the problem: The price of the premature encashment should really be determined by the cost of replacing the deposit in the current market rate structure. This would imply that when rates are rising, the cost of premature withdrawal could even mean a negative interest rate; in the contrary scenario, the depositor could get more than the contracted interest rate.
The other reason advanced by bankers for the stickiness of the prime rate is the linkages to agricultural and export credit. The solution is simple: If subsidised rates are to be maintained, the formula needs to be revised so as to de-link it from the prime rate.
As for monetary aggregates, I have always been puzzled by the announcements made by central banks of targeted growth in M3, and linking it to the banking systems’ deposit growth. First, the policy objectives of the two are different: In the case of M3, to limit the growth; in the case of bank deposits, it is to increase the level in the pursuit of “financial inclusion”. Second, surely the cause and effect relationship is not so much from M3 to deposits as it is the other way round — deposit growth leading to M3 growth, with the central bank adjusting the reserve requirements if it is too high? Another puzzle of course is why we still stick to M3 when most other countries seem to be looking at interest rate as the target variable, ignoring the monetary aggregates: This too, when in each of the three years preceding the last (i.e. 2005-06, 2006-07, 2007-08), both the targeted aggregates have been exceeded by significant margins. (The last fiscal was an exception to this — but then it was hardly a “normal” year.)
It is a good thing that the central bank is appointing a committee to review the operation of the benchmark prime lending rate system. (As argued above, there is a case to review the operation of the LAF system.) I have often felt that one of the reforms of the PLR system should be to eliminate the uncertainty about the timing of a change, by making PLR changes only on specified dates — say, the first day of each quarter. To my mind, this would have two benefits:
