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Economics Class 03

Previous Class Topic

  • Brief overview of how repo rate adjustments can influence money supply and interest rates.
  • Comparison between term deposits and demand deposits in terms of interest offerings.

Operation Twist and Its Effects

  • Simultaneous Buying/Selling of Bonds
  • Involves selling short-term securities while buying long-term ones.
  • Aimed at pushing down long-term yields to make long-term loans more affordable.
  • Impact on Long-Term Loan Rates
  • By reducing supply of long-term bonds (through central bank purchases), prices rise and yields fall.
  • Objective is to encourage banks to extend cheaper credit for home, car, or infrastructure loans.
  • Minimizing Inflationary Impacts
  • The central bank also sells short-term bonds to absorb liquidity, preventing excessive money creation.
  • This balancing act ensures that purchasing power remains relatively stable.

Bond Prices, Yields, and FD Interest Calculations

Bond Prices and Yields

  • Inverse Relationship
  • When bond prices decrease, yields increase, and vice versa.
  • Yield is calculated by dividing the coupon payment by the current market price of the bond.
  • Coupon vs. Yield to Maturity
  • Coupon is the annual interest based on face value.
  • Yield to maturity entails a full time-value-of-money calculation over the bond’s life, whereas current yield uses coupon/current price.

Fixed Deposits (FD)

  • Non-Negotiable Instrument
  • FDs offer a fixed annual interest (e.g., 7.1%), often calculated quarterly or half-yearly and then added to the principal.
  • Comparisons with Demand Deposits
  • Term (FD) interest is higher (e.g., 7.1%) compared to demand deposits (e.g., ~4.4%).
  • Some variations exist by bank, with possible extra benefits for senior citizens.

Yield Curve Orientation

  • Long-Term vs. Short-Term
  • Typically, longer-maturity bonds (e.g., 10-year government securities) give higher yields.
  • Government securities (G-secs) at around 7% can guide banks’ loan pricing.
  • Bank Alignment with G-Sec Yields
  • If longer-term G-sec yields drop, banks might reduce equivalent long-term lending rates.
  • Alternatively, if G-sec yields are too low, banks can prefer lending over holding bonds.

Monetary Transmission Mechanism

Definition and Rationale

  • Process of Policy Rate Effects
  • Reflects how a central bank’s monetary policy decisions, such as repo rate changes, transmit through the banking system to real sectors (households and businesses).
  • The goal is to manage inflation and money supply effectively.
  • Challenges in Transmission
  • Delays or incomplete adjustments by banks in lending rates hinder the effectiveness.
  • Banks cite various costs and legacy deposit rates as reasons for not promptly mirroring repo rate changes.

Deregulation and Evolution of Lending Rate Framework

1994 Deregulation

  • Interest Rate Flexibility
  • Banks were allowed to set interest rates above certain loan amounts.
  • Shifted from a fully regulated environment to partial flexibility.

Benchmark Prime Lending Rate (BPLR)

  • Introduced in 2003
  • Banks posted a “prime lending rate” for their most creditworthy clients.
  • Lack of a uniform formula led to opaque and inconsistent rates among banks.
  • Corporates often received preferential rates, while small borrowers faced higher costs.

Base Rate System

  • Minimum Interest Rate for Loans
  • Implemented around 2010 to ensure no loans were extended below a certain threshold (except specific exemptions like agricultural loans).
  • Key Components
  • Average cost of funds, cost of maintaining CRR (Cash Reserve Ratio), the partial returns on SLR (Statutory Liquidity Ratio) investments, and a margin for net worth.
  • Banks decided how much weight each component should receive, leading to variations in base rates.
  • Problems Identified
  • Banks tended to use older, higher deposit rates in calculations rather than current repo rate changes.
  • Base rate revisions were not in sync with frequent repo rate adjustments.
  • Monetary transmission slowed, and policy rate cuts did not swiftly translate to cheaper loans.

Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) Costs

  • CRR Requirement
  • Banks must hold a certain percentage of their deposits in cash, earning no interest.
  • This increases the bank’s cost of funds, as those resources could otherwise be loaned out.
  • SLR Requirement
  • A specified portion of deposits must be kept in liquid assets like cash, gold, or government securities.
  • Although G-secs offer returns, these rates might be lower than the bank’s deposit costs, adding to expenses.
  • Effect on Bank Pricing
  • Banks incorporate CRR and SLR carrying costs into the base rate or other interest rate regimes.
  • Higher obligations mean banks need to recover these costs through lending margins.

Transition to MCLR (Marginal Cost of Funds Based Lending Rate)

Rationale for MCLR

  • Inefficiencies in Base Rate
  • Banks often claimed high average costs, ignoring current market conditions.
  • Repo rate changes were diluted by fixed longer-term deposit rates.
  • Key Concept: Marginal Cost
  • Focuses on the cost of newly acquired funds rather than historical averages.
  • Encourages banks to pass changes in policy rates on to borrowers more swiftly.

Main Components of MCLR

  • Marginal Cost of Funds (92 percent Weight)
  • Emphasizes the current or additional cost of funding acquired through new deposits, repo borrowings, or bond issuances.
  • Older deposit rates are largely excluded to reflect the updated market environment.
  • CRR Cost and Operational Expenses (Remaining 8%)
  • Includes carrying cost of CRR and day-to-day operational costs.
  • Banks cannot inflate this portion significantly, as the bulk is tied to marginal cost calculations.
  • Tenor Premium
  • Acknowledges that longer-term loans carry higher risk, warranting a premium.
  • Different MCLR rates are set for overnight, monthly, quarterly, and annual tenors, among others.

Monthly Publication of Rates

  • Frequency of Updates
  • MCLR rates are typically revised monthly, ensuring they stay current.
  • Each tenor can have a separate MCLR, typically displayed on bank websites.

Consequences for Lending Rates

  • Rate Calculation
  • Final lending rate = MCLR (for the chosen tenor) + Spread (profit margin, risk assessment).
  • Promotes transparency, since borrowers can clearly see the margin banks charge over the benchmark.
  • Persisting Gaps in Transmission
  • Although more reflective of repo rate changes, immediate and full transmission can still face delays.
  • Some banks may wait for deposit repricing or shift deposit rates slowly.

NPAs, Double Financial Repression, and TBS (Twin Balance Sheet)

Non-Performing Assets (NPAs)

  • Burden on Banks
  • High levels of NPAs reduce profitability because failing loans do not generate expected returns.
  • Banks become hesitant to lower lending rates, fearing revenue shortfalls when they are already absorbing losses.

Double Financial Repression

  • Restrictions on Assets
  • Banks must fulfill obligations like CRR, SLR, and priority sector lending, limiting flexibility.
  • Priority sector loans (e.g., agriculture, MSME) can yield lower returns than market-based lending.
  • Restrictions on Liabilities
  • Competition from small savings schemes and alternative investments can force banks to keep deposit rates attractive.
  • Balancing deposit mobilization with lower lending rates becomes costly.

Twin Balance Sheet Syndrome (TBS)

  • Corporate-Bank Interdependence
  • Corporations unable to repay debts weaken bank balance sheets, leading to tighter credit supply.
  • The chain reaction hampers economic growth when both corporations and banks struggle simultaneously.
  • Economic Impact
  • Banks, saddled with defaults, become cautious. Corporates, burdened by debt, cannot expand or invest.

Shift to External Benchmark Lending Rates

Limitations of MCLR

  • Less than Full Transmission
  • Some banks still hesitated to cut rates in line with repo rate changes.
  • Ongoing issues with deposit repricing and balance sheet constraints lingered.

RBI’s Mandate for External Benchmarking

  • Purpose
  • Enhance transparency by linking lending rates to external reference points not set internally by banks.
  • Options include the repo rate, 91-day treasury bill yield, 182-day treasury bill yield, or market rates specified by authorized entities.
  • Mechanics
  • Banks must change interest rates at least once every three months to reflect the external benchmark.
  • Customers can easily compare the “spread” a bank charges above the benchmark.

Effects on Deposit and Lending Rates

  • Automatic Adjustments
  • When the benchmark (e.g., repo rate) goes down, loans see faster rate cuts.
  • Banks often lower deposit rates to maintain margins, impacting savers.
  • Transparency and Competition
  • Borrowers can see whether a bank’s spread is higher or lower than peers.
  • Encourages borrowers to switch if they find more competitive lending terms.

Treasury Bills and Their Role

  • Short-Term Government Securities
  • Issued at a discount and redeemed at face value, which provides the return.
  • Typically mature in 91 days, 182 days, or 364 days; used by banks to meet SLR if needed.
  • Interest Rate Benchmarks
  • T-bill yields often track policy rates (e.g., repo rate), making them suitable external benchmarks.
  • Being zero-coupon, they reflect market conditions without declared coupon payments.

Inflation Targeting and the Monetary Policy Committee (MPC)

Inflation Targeting Framework

  • Primary Objective
  • Keep Consumer Price Index (CPI) inflation close to 4%, within a tolerance band of 2%–6%.
  • Emphasis on curbing price rises to preserve purchasing power.
  • Consumer Price Index (CPI)
  • Tracks a representative basket of goods and services weighted by expenditure patterns.
  • Measures retail-level prices that consumers pay, considered a critical gauge of cost-of-living changes.

MPC Composition and Decision-Making

  • Six-Member Body
  • Includes the RBI Governor (as chair) and government-appointed experts.
  • Each member votes on key policy rates (e.g., repo rate), with the Governor holding a tie-breaking vote if needed.
  • Bi-Monthly Reviews
  • The committee meets regularly to assess economic indicators like inflation, growth, and global conditions.
  • Their decisions aim to balance inflation management with promoting sustainable economic growth.

Coordinating Fiscal and Monetary Policy

  • Monetary Policy Framework Agreement
  • Formalized guidelines between the government and the RBI to align inflation targets with fiscal actions.
  • Ensures accountability if inflation remains outside the set band for an extended period.
  • Repo Rate Adjustments
  • Used as a lever to increase or decrease the cost of borrowing.
  • Tighter monetary policy fights elevated inflation, whereas looser policy supports growth if inflation is moderate.

Global Factors and Recent Trends

  • Pandemic Impact and Economic Stimuli
  • Lockdowns suppressed demand initially but led to pent-up consumer demand later.
  • Simultaneous supply chain disruptions and war-related issues caused cost-push inflation globally.
  • Rapid Rate Increases
  • Many central banks, including the RBI, raised rates when inflation began to surge.
  • Higher borrowing costs tempered spending in certain segments, although credit uptake remained robust in consumer-driven economies.

Topic to be Discussed in the Next Class
- Deeper examination of current monetary policy settings and repo rate decisions.
- Inflation trends in relation to domestic and global economic conditions.