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Monetary Policy is Overrated

Apr 7, 2017

28

Dear Reader,

The RBI presented the first monetary policy for this financial year yesterday. It decided to keep the repo rate fixed at 6.25 per cent. Over the last few months, I have come to the conclusion that the monetary policy in India is basically overrated. And I offer reasons for it in what you are about to read. This piece was first published as a part of the Vivek Kaul Letter on March 24, 2017. You can subscribe to the Letter here.

Happy Reading!
Vivek Kaul

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The next meeting of the monetary policy committee of the Reserve Bank of India(RBI) is scheduled on April 5 and 6, 2017. As John Lanchester writes in How to Speak Money: "Monetary means to do with interest-rates, and is controlled by the central bank."

Around that time, the business media will go on an overdrive. Economists will be called up and surveys will be run on by how much they expect the RBI to cut the repo rate. After the monetary policy is in the public domain, more stories will be done on whether the RBI should have cut more, if it cuts the repo rate at all.

If it doesn't cut the repo rate, then stories will be done around why the RBI should have cut the repo rate and by not cutting the repo rate how the central bank is hurting the economy.

Over the past few years as the RBI has cut the repo rate there has been a demand for greater interest rate cuts. Repo rate is the interest rate at which the RBI lends to banks, in case banks are short on funds. It acts a sort of a benchmark for interest rates in general.


So, it's been so observed, if the RBI cuts the repo rate by 25 basis points, it's said that a 50-basis points rate cut should have been carried out. One basis point is one hundredth of a percentage. Typically, people making these statements belong to the real estate industry, industry lobbies or the government.

Of course, the media never bothers to ask the fixed depositors who are living on the income from their fixed deposits, on what do they think about lower interest rates on their fixed deposits. This is a story which I have been waiting to read for many years. In case, any editor in the pink press is reading this and you are able to do so, I request you to commission this story next time the RBI repo rate cut is followed by banks cutting interest rates on their fixed deposits.

What is the logic here? The faster the RBI cuts the repo rate, the faster the banks will cut their borrowing and lending rates. The more individuals and corporates will borrow, spend and expand. And all this will work out well for the economy. In fact, sometimes the impression that is given in the media is that all that India needs to grow again at growth rates of 9-10 per cent, are lower interest rates. No one seems to be bothered about the fact that around of half of household financial savings are in the form of fixed deposits. And lower interest rates on this front will also lead to lower consumption or even higher savings for those who are trying to save in order to meet future goals.

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The question is, if the lower interest rates leading to higher economic growth argument, is straightforward as it sounds? As John Kenneth Galbraith writes in The Economics of Innocent Fraud: "The false and favourable reputation of the Federal Reserve [the American central bank] has a strong foundation. There is the power and prestige of banks and bankers and the magic accorded to money. These stand behind and support the Federal Reserve and its member-that is, belonging banks. If in recession the interest rate is lowered by the central bank, the member banks are counted on to pass the lower rate along to their customers, thus encouraging them to borrow. Producers will then produce goods and services, buy the plant and machinery they can now afford and from which they can now make money, and consumption paid for cheaper loans will expand. The economy will respond, the recession will end."

This belief is universal and not just in the United States, in the context of which Galbraith wrote the above paragraph. If we were to replace the words Federal Reserve in the above paragraph with Reserve Bank of India, the logic would stay entirely the same. While Galbraith uses the word recession in the American context, we need to say slow economic growth, in the Indian context.

The question is do consumers borrow and spend and producers or companies borrow and expand, when the central bank cuts the interest rate, leading to banks cutting their lending rates as well. As Galbraith writes: "The difficulty is that this highly plausible, wholly agreeable process exists only in the well- established economic belief and not in real life. The belief depends on the seemingly persuasive theory and on neither reality nor practical are in the form of fixed deposits. And lower interest rates on this front will also lead to lower consumption or even higher savings for those who are trying to save in order to meet future goals.

The question is, if the lower interest rates leading to higher economic growth argument, is straightforward as it sounds? As John Kenneth Galbraith writes in The Economics of Innocent Fraud: "The make money, and consumption paid for cheaper loans will expand. The economy will respond, the recession will end."

This belief is universal and not just in the United States, in the context of which Galbraith wrote the above paragraph. If we were to replace the words Federal Reserve in the above paragraph with Reserve Bank of India, the logic would stay entirely the same. While Galbraith uses the word experience. Business firms borrow when they can make money and not because interest rates are low."

Since Galbraith talks about practical experience, let's look at Indian data over the last few years. Let's start with Figure 1. Figure 1 essentially plots the repo rate over the last few years. As mentioned earlier, repo rate is the interest rate at which the RBI lends to banks short on funds.

Figure 1

As can be seen from Figure 1, the RBI started cutting the repo rate from January 2015 onwards. The repo rate has fallen by 175 basis points from 8 per cent to 6.25 per cent. Has this cut in interest rates led to an increase in lending?

Let's take a look at Figure 2. Figure 2 essentially plots the annual increase in non- food credit growth of banks, over a period of time. Among other things, banks give working capital loans to Food Corporation of India and state procurement agencies to carry out their food procurement operations for the government. We ignore these loans here.

Figure 2 shows annual increase in non-food credit from March 2013 onwards. Each data point essentially plots the one year growth in bank lending. Hence, a growth of 13.98 per cent in March 2013, means a growth of 13.98 per cent in bank lending between March 2012 and March 2013.

Figure 2

Figure2 makes for a very interesting reading. As mentioned earlier the RBI started cutting the repo rate from January 2015 onwards. In January 2015, the one year growth rate of bank credit had stood at 11.2 per cent. As repo rate was cut, the non-food credit growth rate actually fell and remained lower than 11.2 per cent. In September 2016, it briefly touched 12.25 per cent. In January 2017, it had stood at 6.2 per cent.

Hence, as the repo rate was cut, the growth rate in bank lending instead of going up started to fall. This goes totally against the prevailing economic theory. Let's look at some more data. Figure 3 plots the annual growth rate in industrial lending.

Figure 3

Figure 3 clearly shows that as the repo rate has been cut, the growth rate in industrial lending has fallen and fallen dramatically. In fact, in January 2017, industrial lending of banks had contracted by over 5 per cent. This despite a 175 basis points fall in the repo rate over a two-year period.

Now let's take a look at Figure 4.

Figure 4

Figure 4 plots the growth in retail loans (or what the RBI calls personal loans). Retail loans include home loans, car loans, two-wheeler loans, loans against fixed deposits, credit card outstanding, consumer durables loans and what we call personal loans.

Figure 4 makes for a very interesting read. In October- November 2014, before the repo rate cuts of the RBI started, the growth in retail lending was around 16 per cent. After the repo rate cuts, the growth rate in retail lending peaked in April 2016 at 19.75 per cent. Since then it has fallen, and in January 2017, it stood at 12.9 per cent. This fall can be attributed to demonetisation.

Hence, in case of retail loans lower interest rates did have some impact on the overall growth of loans. But the impact wasn't huge as is normally projected in the media.

What all this clearly tells us is that the impact of monetary policy on bank lending is clearly limited, against what the conventional wisdom tells us. This is primarily because at any point of time there are other factors at work as well.

In the Indian case, there is what the Economic Survey calls the twin- balance sheet problem. During the go-go years, the Indian corporates overborrowed and are now having a huge problem repaying their loans. This has put many Indian banks, primarily the public-sector banks in a huge amount of trouble. Hence, these banks are in no mood to lend to the industry.

As the Economic Survey points out: "Typically, countries with a twin balance sheet (TBS) problem follow a standard path. Their corporations over-expand during a boom, leaving them with obligations that they can't repay. So, they default on their debts, leaving bank balance sheets impaired, as well. This combination then proves devastating for growth, since the hobbled corporations are reluctant to invest, while those that remain sound can't invest much either, since fragile banks are not really in a position to lend to them."

This comes out very clearly in the fact that over the last six months, total bank lending to industry has actually fallen and can be seen in negative growth rates in Figure 3. So, the RBI can keep cutting the repo rates by as much as it wants, if the banks don't want to lend to corporates, they don't want to lend to corporates. In March 2013, industrial lending formed 46 per cent of total bank lending. By January 2017, this had fallen to 39 per cent. This is something that the monetary policy cannot set right.

Take a look at Figure 5.

Figure 5: Repo, Base Lending Rate and Term Deposit Rate (Per cent)

What does Figure 5 tell us? It tells us very clearly that while the repo rate and the average term deposit rate or the rate of interest that banks pay for their fixed deposits, have fallen, the average base rate of banks hasn't fallen at the same pace. The base rate is interest rate at which banks lend to their best customers.

What does the base rate of banks not falling at the same speed actually mean? It means that the lending rate of banks hasn't fallen at the same pace as its borrowing rate as well as the repo rate of the RBI. This is primarily because the banks have accumulated a lot of bad loans on their corporate lending, and they want to cushion some of this impact by ensuring that their lending rates don't fall as fast they should. This basically increases the margin at which they lend and has neutralised much of the impact of the monetary policy where the repo rate is falling.

The larger point is that consumers and producers can counter the monetary policy in their own way by the rate at which they borrow and spend money and borrow and invest money. As George Gilder asks in The Scandal of Money-Why Wall Street Recovers But the Economy Never Does: "The people (including bankers) could counteract any given monetary policy merely by changing the rate at which they spend or invest the dollars. Why monetary theory disregards the possibility has long been an enigma to me."

Once this possibility is taken into account then it is easy to understand that people can render monetary policy ineffective. As Gilder puts it: "We the people control [money]."

To conclude, it is important to understand that money is a very complicated phenomenon and it cannot be controlled by a central bank or a monetary policy committee within that bank.

Galbraith puts it best when he says: "The belief that anything complex, as diverse and by its nature personally as important as money can be guided by well-discussed but painless decisions emanating from a pleasant, unobtrusive building [the central bank headquarters]... belongs not to the real world but to that of hope and imagination. Here [is] our most implausible and most cherished escape from reality. No one should deny those participating their innocently acquired prestige, their sense of personal competence, their largely innocent enjoyment of what in economic effect is a well-established fraud. Perhaps we should let their ineffective role be accepted and forgiven."

The moral of the story being that in early April when the next monetary policy will be presented and when the media and the economists will go on an overdrive over it, you dear reader, can stay away from it and not waste your precious time. Rest assured, if the monetary policy does make an important point, I will write about it in this Letter.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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6 Responses to "Monetary Policy is Overrated"

Roosevelt Fernandes

Apr 14, 2017

The Monetary Policy in India is decoupled from the Economy. No amount of rate reductions will address the core isses of apathy, greed and opportunism. I agree with the author.

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P R Subramanian

Apr 9, 2017

The Banker's and consumer's reaction to the monetary policy is well explained with relevant statistics

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DWARAKANATH VALLAM

Apr 8, 2017

I think it is better to make comparisons if we can get the following two graphs.
a.year on year trend of lending to new businesses.-regionwise bankwise.
b.year on year trend of lending to serious ( non defaulting) businesses-small/medium/big -regionwise bankwise.
This will readily give the reason whether rbi's monetary policy will have any impact on lending/growth of economy.

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Pradeep

Apr 8, 2017

Undoubtedly, I agree with your view that monetary policy is overrated. As of now, monetary policy doesn't effect the lives of common people at all, mainly because you do not expect any rate cuts and even if there are some rate cuts, the benefits transmitted to common people are negligible. On top of it the , banks have worked full time to ensure that disadvantages of rate cut i.e lowering of fixed deposit rates are transmitted extremely quickly and more than 100%.
Now if there will be some increase in rates, reverse will be followed by banks - they will immediately increase interest on loans but will take years to increase fixed deposit rates.
Citizens, specially senior citizens who are dependent on these fixed deposits , suffer maximum and off course big businesses who take big loans (which later get restructured, waived off etc.) are the beneficiaries of the system.
Any solution ? - not at all as this is such an organised loot which involves all the so called builders of nation - government, banks, businesses ....

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T NAGA SRINIVAS

Apr 7, 2017

After reading much of your stuff, like the point you are trying to make on "Over rated monetary policy", I came to the conclusion that you are a highly over rated writer.

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E Vishwa Nathan

Apr 7, 2017

Your column is the only one which takes up the cause of the private sector retirees cause who suffer badly due to the decreasing interest rates on bank fixed deposits, their only, secure source of income. Please continue to press this issue strongly.

Thank you.

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