The RBI chose to pause and hold key policy repo rate at 5.15 per cent, contrary to expectations of a rate cut. While there was a compelling case to lower the repo rate, given the sharp slowdown in economic growth, the RBI opted to wait before embarking on further rate cuts.
While the RBI’s decision to pause may have jolted the markets, the move is prudent, given the near-term risk to CPI inflation that had moved up in October. While core inflation can moderate in the coming months, a sharp rise in food inflation is likely to keep the overall CPI inflation elevated.
But more importantly, a pause was warranted, as even after the 135-basis-point reduction in repo rate transmission to borrowers has been weak. Despite repo-linked loans offering some respite, borrowers have not gained significantly from the RBI’s rate reduction so far. Taking stock of the transmission of rate actions is imperative before cutting rates further. One of the key reasons for weak transmission across various interest-rate structures – from pre-PLR (prime lending pate) to base rate to MCLR (marginal cost of funds-based lending rate) – has been that banks source only a minuscule portion of their funds (1 per cent) from the repo window. Since they rely significantly on longer-term deposits, a cut in repo rate does not immediately reduce their costs, limiting their ability to lower lending rates.
The RBI mandating banks to move to repo-linked loans was sought to address this issue. But most banks have added significant spread to the underlying benchmark, which has led the effective lending rates to be still high.
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For instance, Bank of Baroda offers home loan rates of 8.3 to 9.3 per cent under the erstwhile MCLR; under the new repo-linked structure, the effective lending rates work out to 8.15 to 9.15 per cent. The modest difference between the two is because of the mark-up of 3 per cent over repo rate that the bank charges. SBI charges 2.65 per cent spread over repo, while Union Bank charges 2.85 per cent. In most other banks, too, higher spreads have eaten into the benefit of lower repo rate, leaving little respite for borrowers.
Unlikely to change
So, why are banks charging a significant mark-up or spread over repo? One reason could be that banks are building in ample buffer by way of spread to protect margins in repo-linked loans. Banks normally lower lending rates when they are able to cut deposit rates and bring down their costs. However, under the repo-linked structure, banks may be compelled to lower lending rates faster than their deposit rates, hurting margins.
This is because only a small portion of deposits gets re-priced in the short term and, hence, re-pricing loans at short intervals (under repo-linked structure) would hurt.
The pain is more for private sector banks that have high credit-deposit ratio of over 80 to 90 per cent. With deposits growing relatively slower than loans, there is little headroom for cutting deposit rates aggressively. Interestingly, private banks have been offering attractive fixed deposit rates over the past year to address weak deposit flows. A relatively higher share of term deposits will keep the cost of funds high, adding pressure on margins. It is possibly because of this that banks have kept spreads high under repo-linked loans.
Another factor behind weak transmission has been the wide spread between 10-year government bonds and shorter tenure bonds. Since September, the spread between 10-year G-Sec and two-year G-Sec has widened to 90 to 100 basis points. Data suggest that such wide divergence was last seen in 2009 and in the beginning of 2010. The stickiness of the 10-year G-Sec has been a key reason for the weak transmission of policy rates.
The RBI has also stated that while the transmission of the 135 bps cut in repo rate has been to the extent of 137 bps in the overnight call money market and 218 bps in three-month CPs, it has been lower at 113 bps for five-year and 89 bps for 10-year G-Secs. Growing concerns over fiscal slippages can keep the 10-year G-Sec yield elevated, accentuating the problem. Unless long-term yields fall, transmission could remain an issue.
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