By: Arjun Tandon, Christ university, Bangalore
The Reserve Bank of India is scrutinised for many things, but mainly for poor monetary transmission. The policy rates, when changed, do not affect lending or deposit rates in a similar proportion.
The RBI has taken various measures to ensure faster translation of policy rates by introducing the Marginal Cost of Lending Rate (MCLR) etc. There is not much more that they can do. The problems with effectively transmitting monetary policy arise due to less dependence on the Reserve Bank for funds.
Banks in India are known to avoid borrowing from the central bank and use domestic funds instead, as far as possible. Faster transmission of repo rate is seen in short term G-Sec bonds, as opposed to in 10-year G-sec yields.
With borrowing rates falling north of 100 basis points in the last year, short term floating rate G-Sec prices have gone up, and consequently yields have gone down. This has worked favourably to form an upward sloping yield curve with 10 year yields almost touching 6%.
The increase in G-Sec yields or even deposit rates in banks will not have the expected impact on inflation or consumer spending. The younger generation has a tendency to spend more of its disposable income, and undermine the propensity to save that Indian markets are used to.
The inadequate knowledge with banks, especially PSBs, about its borrowers also makes monetary transmission inefficient.
The following is the Balance Sheet channel, which is a part of the Credit channel of monetary transmission as given by Frederick Mishkin (1995):
M(+) => Pe(+) => Adverse selection(-) => Lending(+) => I(+) => Y(+)
M(+) is an expansionary monetary policy, Pe(+) implies an increase in equity prices, I(+) indicates an increase in investment expenditure and Y(+) means an increase in national income.
The expansionary monetary policy currently being followed, should, according to this channel, decrease adverse selection. However, with much of the credit being diverted towards MSMEs through the stimulus package, who are already at high default risk, breaks down the previously made assumption about reduced adverse selection.
With businesses facing a major cash crunch, PSBs have essentially gone on lending sprees to meet credit demands, which increases exposure to failing businesses.
As NPA declaration is due in May-June of 2021, and with prospects of a bad bank being set up before that seeming bleak, Public Sector Banks are going to have a huge NPA problem. This will lead to a cautious approach going forward, which means less credit, and consequently less investment expenditure.
This happens due to incompetent KYC measures taken by banks, especially PSBs, and thus swells up the risk of default. However, banks have become more vigilant than they were 5 years ago.
Dr. Rajan, in his short tenure as Governor, kept two things in check: Inflation and NPAs. Inflation during his tenure fell from over 9.5% in 2013 to below 5% by the time he left office in 2016. He was the one to introduce Inflation targeting (4% with a band of 2%), and was the one to shift the central bank’s focus more towards the monetary side by establishing the Urjit Patel Committee, which consequently proposed setting up the Monetary Policy Committee.
With respect to NPAs, the former governor was also responsible for pushing banks to declare their Non-Performing Assets to show the true colours of the asset quality. This not only decreases the risk of financial fraud ending in a financial crisis, but also helps the central bank understand better where to direct its assistance.
Since January of 2014, under Dr Rajan and then Dr Urjit Patel, the repo has been slowly lowered by 25 basis points all the way from 8% to finally 6% in February of 2018. While this was a monetary variable being manipulated, it helped in increasing tax revenue of the government.
The gradual lowering of Repo, accompanied by the initial boom in efficiency in collecting taxes owing to the introduction of GST caused an increase in Tax Revenues. How does a lower repo rate contribute to tax revenues?
With a lower cost of borrowing, investment expenditure increases causing financial markets to boom, credit to flow more easily through the economy, and spur growth. In the process, it creates situations for the government to extract more tax revenue in absolute terms assuming that taxes remain constant.
When financial markets are in an upswing, profitable long positions make more investors liable to pay capital gains tax. Transactions costs add up as their frequency increases in the market with increased participation. Increased investment in businesses, a favourable Debt Service Coverage Ratio (DSCR) owing to lower costs of borrowing makes firms more profitable and expands their balance sheets. With corporate tax remaining constant, its collectibles in real terms go up.
Thus, a common tax regime, lower cost of borrowing, accompanied with an NPA clean-upstrengthened the general financial system, and helped monetary changes play favourably in the hands of the fiscal authorities. However, recent data of 2019 and 2020 shows lowered GST collection, an exorbitant rise in borrowing, accompanied by an ever-decreasing PPP of the Indian Rupee making repayment that much more difficult, and thus lowering the ability of future governments to borrow.