India’s transmission of repo rate changes has improved over time

The reasons are quite clear.

First, RBI changed its stance in its last policy statement to ‘accommodative.’ It also issued a clarification of its stance nomenclature, saying that the shift could mean a further lowering of policy rates. Second, liquidity has been provided on a near real-time basis by RBI to ensure that the system is in surplus.

Third, RBI lowered its inflation forecast to 4% for 2024-25, with the India Meteorological Department (IMD) providing further comfort by forecasting a normal monsoon this year. And last, RBI’s projection of growth in India’s gross domestic product (GDP) has been downgraded a tad, which is the clinching argument for lowering rates.

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The issue that has always arisen when it comes to the effectiveness of monetary policy is the transmission process. RBI can alter the repo rate, which is the rate at which the central bank lends money overnight to commercial banks, but for such a policy action to effectively alter the cost of credit in the economy, lenders need to respond in a similar manner.

To streamline the process, RBI brought in the concept of the ‘external benchmark lending rate’ (EBLR), which holds for retail loans as well as those extended to micro, small and medium enterprises (MSMEs). Under this, any change in the benchmark, which is usually the repo rate, ensures full transmission to loan rates. But for corporate borrowers, it is the marginal cost lending rate (MCLR) that matters. And this is dependent on deposit rates. For private banks, almost 85% of the portfolio is linked to the EBLR, while that proportion stands at 45% for public sector banks.

For banks to change the MCLR, which is formula driven, deposit rates need to change. This depends on the demand-and-supply balance of the fund flows of individual banks. In this context, it’s useful to analyse how interest rates in the banking sector reacted to repo rate changes in the past.

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Since 2011, there have broadly been seven repo-rate regimes under which RBI’s policy rate moved either up or down. For the purpose of analysis, the mid-point of the average 1-year deposit rate of the banking system has been used here. On the lending side, the MCLR has been used from 1 April 2016 onwards, while the base rate has been taken into account for earlier years. Here too, the mid-point of the range has been taken as the indicative reference point.

The table alongside has data on changes in the repo rate, deposit rate and MCLR/base rate, along with the responses of deposit and lending rates to repo rate changes under different rate regimes. Some interesting observations can be made.

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First, there is rarely any equivalence in the responses of either the deposit rate or the MCLR when the repo rate is changed. The only time when the response was over 100% was under the fifth regime, which was the shortest too and involved just one rate increase.

Second, the responses have been quite diverse across these regimes. While the direction has been the same, the extent to which rates have responded has varied.

Third, in the first four time periods, an increase in the repo rate drew a sharper response from the lending rate (base rate) than the deposit rate, while a decrease in the repo rate saw deposit rates react with more alacrity.

Fourth, since June 2018, the responses of deposit rates and MCLRs appear to be better aligned. Ever since the MCLR came into existence, there has been better transmission compared with earlier times when banks used the base rate. During the January 2015 to May 2018 period, a span that saw repo-rate reduction of 200 basis points and banks adopt the MCLR (starting fiscal year 2016-17), had only the base rate been used, the lending rate would have fallen by only 105 basis points, instead of the 117.5 basis points that was actually recorded. Therefore, the 2016 shift from the base rate to the MCLR can be said to have improved the transmission of monetary policy.

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One factor playing a decisive role in the background has been the growth of India’s mutual fund industry. When the stock market is buoyant, a migration of savings is observed from bank deposits to mutual funds, which are preferred by individual households. In recent years, this trend has been quite pronounced. The assets under management of mutual funds increased by 53% and 77%, respectively, in the two repo-rate regimes after 2019, reflecting this preference.

In recent years, therefore, banks have been cautious about lowering deposit rates even if the repo rate has been lowered, as this could magnify the shift from deposits to mutual funds.

What can all this mean for the future transmission of repo rate cuts? Consider the regime from April 2019 to April 2022, involving 225 basis points of cumulative cuts in the repo rate, a period that included the covid pandemic; this period recorded a 70% transmission in the deposit rate and 69% in the MCLR. We can take this to be the best-case scenario.

The repo regime from May 2022 to January 2025 had a 250-basis points rise in the repo, with a 53% transmission to the deposit rate and 60% to the lending rate.

As for the policy-easing cycle that began this year, the final transmission might lie in a range of 60-70 basis points, assuming that the repo rate is cut by 100 basis points in all, as mentioned earlier. Deposit rates are expected to undergo less of a change than lending rates, as there are other factors driving the former.

Broadly, the data shows that there has been a distinct improvement in the transmission of repo rate changes, especially over the last five years. This is welcome, as it means that the effectiveness of India’s monetary policy has sharpened.

These are the author’s personal views

The author is chief economist, Bank of Baroda, and author of ‘Corporate Quirks: The darker side of the sun’