Lost in transmission !

For unschooled mortals , there could be nothing boring like RBI policy action. Yet , the glamour around it never seems to subside . On the eve of every monetary policy , without exception , mercury levels meteorically rise  in the  media . Rate action   takes the center stage and debates around it dominate the pink papers . Every word and utterance of RBI governor get dissected frantically for cues on future direction .  It was no different in this cycle with  all monetary policy events  attracting hyped up attention.

But what has surprised seasoned pundits is that the impact of these policy actions have rarely lived up to the initial hype , going by their effects on what matters materially to the real economy i.e. lending rates .  RBI had cut repo rates by 25 bps (basis points, each basis point refers to one hundredth of percentage) three times in the last one year . Yet , lending rates by banks have barely budged . Even bond markets which normally transmits the cuts quickly , have remained stubborn after the initial enthusiasm. There is not more than 20 bps ( max ) reduction in the banking system while about 40 to 50 bps response in the bond market .

Where is the dichotomy and why is so much hype around RBI monetary event that has no material impact on the lending rates . What many in the market fail to understand is that RBI policy actions merely act as a signaling mechanism and much of what happens to the final interest rates is determined by what transpires in the transmission channel  . Banks and bond markets form the big part of the so called transmission channel .  While rate actions quickly travel thro bond markets , banking channel is a high density medium with high transmission losses . Banks with their high reliance on long-duration fixed deposits for its source of funding   can hardly transmit the rates without re-pricing the FDs ( happens on maturity). Unlike developed countries  where bond markets are deep and mature , much of the credit flow in the economy  happens thro’ banking channel in India and hence the inefficacy of RBI policy actions.

As per the data released by SEBI for 2011 , banking loans  constituted over 38% of the GDP while corporate bond market shared less than 10% . In developed countries , this ratio is highly skewed towards corporate bond markets . As per the chart shown below ( World Bank data for 2012) , corporate debt as a percent of GDP was over 90% for US and even for countries like Korea , it was near 60% . No surprise that the rate transmission is much faster in US and in other developed countries .

Bonds

Indian bond markets are far less evolved and lot more shallow than many would admit . Low level of financial sophistication of Indian households is one of the primary reasons for this , besides less developed financial intermediaries and debt markets  . Less than 5% of household savings are in financial markets whereas physical savings ( gold and real estate) grab a much bigger share . Our current political administration has recognized this and taken on the challenge of developing the bond markets .  Govt’s recent plans to shift bond market regulatory powers from RBI to SEBI is in this direction  . This move is part of a major overhaul of the financial system that aims to deepen bond markets by increasing the participation of retail investors and improve the transmission of monetary policy.

It is going to be a long haul before India can reform its bond markets and become the hot choice for global investors . Until then ,  transmission tantrums will continue to taunt the RBI . You know what to expect when the news channels flash headlines like  “ home loan EMI to fall” post the next RBI rate action .

ArunaGiri . N

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