RBI rate cuts evade India's real economy

When India held rates again this month it was less a sign of confidence in the economy or the end of inflationary fears and more an acknowledgment that the process of monetary transmission - the opaque "black box" through which the wishes of the central bank are passed to the real economy - had somehow broken down.

Facing calls to explain why banks had largely failed to pass on to consumers and businesses two policy rate cuts this year, Raghuram Rajan, the normally easy-going governor of the Reserve Bank of India, launched a rare attack.

"Banks are sitting on money," he said after the RBI's latest interest rate meeting. "Their marginal cost of funding has fallen. The notion that it has not fallen is nonsense."

India's transmission mechanism problem is particularly acute, say analysts, because of banks' heavy reliance on deposits for funding, a correspondingly low level of interbank borrowing, and a banking system frozen by high rates of bad loans.

Deposits make up 78 per cent of the total liabilities of India's commercial banks, according to ratings group Crisil, compared with a figure close to 50 per cent in the US. Credit Suisse reckons about 11 per cent of loans are bad or being restructured, with smaller public sector banks worst affected.

That is prompting banks to sit on their hands and margins, afraid to take on new risks ahead of a sustained economic recovery. It is "a case of the past driving the future," says Sajjid Chinoy, chief economist at JPMorgan in India.

The problem is frustrating companies, policy makers and investors - particularly given that, with inflation falling, real rates will rise this year unless the banks start to act.

It also has real political consequences, with Prime Minister Narendra Modi relying partly on rate cuts to revive investment. Credit growth fell to a decade low of 9 per cent in the year to March, according to Crisil, having been above 20 per cent during times of brisker growth.

But it is a situation few expect to change soon.

"In India things work differently from the international banks," State Bank of India chairman Arundhati Bhattacharya told reporters after Mr Rajan's blast. "We are very deposit-based."

Only 1 per cent of SBI's borrowing came from the open market, she explained, meaning policy rate changes reduce the bank's cost of funds slowly and it would take more than the RBI's cuts so far for her bank to reduce lending rates further.

Mr Rajan's words did stir SBI into action - but its modest move illustrates the scale of India's monetary transmission problem. While the RBI has reduced its policy rate by 50 basis points to 7.5 per cent this year, SBI merely trimmed its rates to 9.85 per cent FROM 10 per cent.

That attitude from what many consider the price maker in the market will not please the RBI. "We follow the large players like SBI," says one senior figure at a private sector lender.

Private banks including ICICI and HDFC Bank also trimmed rates by a fraction of the central bank's moves. Many others have not followed suit at all.

Beyond some slow technical adjustments, it is not clear the RBI can push banks to move faster.

"The only real tool the RBI has here is coercion," says Kunal Kumar Kundu, an economist with Societe Generale. "That is the only thing Rajan can really do to make the banks come out of their inertia."

And while the government might be tempted to demand rate cuts from public sector banks - which control about three-quarters of assets - analysts suggest politicians realise that would only sow the seeds of future problems.

"Yes, they are susceptible to political pressure but the political class understands the days of picking up a phone and telling public sector banks what to do are over," says Rajeev Malik, an economist at CLSA.

In many ways India is simply further down the path China is now on as it liberalises interest rates and seeks to improve capital allocation efficiency in its debt-burdened economy.

Most economists predict the RBI will cut rates again soon, leaving both Mr Rajan and Mr Modi to hope that banks will follow suit more quickly. But analysts are far from convinced.

"The banks have done what they needed to do and taken the heat off themselves," Mr Malik say. "[But] the RBI has at most two more rate cuts in it . . . so anyone hoping interest rates will decline so much that it will be a big driver of growth over the next 12 months or so, I think that hope is misplaced."

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