RBI doesn't determine the true interest rate in economy

The Reserve Bank of India's (RBI's) monetary policy in the Indian context can only suggest which side the economy should be headed and cannot push and prod the economy in the direction in which it wants it to go.

Hence, by maintaining the repo rate at 8 percent in its July policy review despite lowering growth forecasts from 7.3 percent to 6.5 percent, the RBI is only signalling that it wants inflation to come off and that lower inflation will then push growth higher. The repo rate then becomes inconsequential for either the direction of inflation or for the direction of the economy.

The repo rate has a direct effect on the overnight borrowing costs of banks. The RBI lends money to banks on a daily basis through the LAF (Liquidity Adjustment Facility) auction. Banks bid for repo in the LAF if they are in need of liquidity and hence any change in repo rate changes the cost of daily funds for banks.

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[caption id="attachment_420986" align="alignleft" width="380"] A change in repo rate can also bring about change in a few fixed income instruments related to the repo rate. Reuters[/caption]

A change in repo rate can also bring about change in a few fixed income instruments related to the repo rate. Short-term instruments with maturities of 91 days and below such as treasury bills (T-bills) and certificates of deposits (CDs) will see yields rise or fall depending on the repo rate. The reason is that banks can fund the purchase of these short-term instruments by borrowing from the RBI at the repo rate.

Longer-term instruments, including government and corporate bonds, will not be directly impacted by repo rates, except due to the sentiment factor. Lowering of the repo rate sends out signals that the RBI is in an easing mode and bond markets will take that positively to bring down government bond yields in the short term. However, if government borrowing increases, government bond yields will rise even if repo rates are cut.

The repo rate will not have a direct impact on lending and borrowing rates in the economy. Bank lending rates depend on various factors including their liquidity position, cost of deposits, capital adequacy and levels of bad loans in their books. Higher liquidity, lower cost of deposits, high capital adequacy and low levels of bad loans will lead to lower lending rates.

The situation at present is not conducive for reducing lending rates, with liquidity being tight as banks are borrowing from the RBI on a daily basis to meet their daily liquidity requirements. The cost of deposits is high at 9-9.5 percent levels for many banks. While the capital adequacy ratio is healthy at present at over 14 percent for most scheduled commercial banks, given rising bad loans that have risen by 50-100 percent over the last one year for public sector banks, this capital adequacy could come under pressure.

The repo rate will also not have an impact on the small savings rate in the economy. The rate of interest on PPF (Public Provident Fund), at 8.8 percent, and the rate of interest on post office deposits, at 8.5 percent, will not change on a change in the repo rate. The rates are fixed by the government based on yields on government bonds, and interest rates on government bonds are more dependent on how the government manages its fiscal deficit and the economy rather than the level of repo rates.

Corporate borrowers in the public and private sectors see their interest rates fluctuate on the back of rise or fall in government bond yields. The credit spread, which is the difference between the yield on a government bond and the yield on a corresponding maturity corporate bond, is determined by many factors, including liquidity and credit risk. Low liquidity and rising credit risk, as determined by rating downgrades, take up credit spreads, leading to higher borrowing costs for corporate borrowers. A change in repo rate does not impact credit spreads.

The fact that the repo rate does not determine the true rates in the economy does not mean that the RBI can afford to be lax on it. The RBI is the only voice that can bring a sense of responsibility to the economy as the government and the corporate sector will always push for cheap rates since it can help fund fiscal profligacy and profits. However, when factors are pointing to a sharp slowdown in economic activity, the RBI has to be proactive with its policy rate.

Leaving the repo rate alone does not help either way.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors