For Monetary Policy Cues, Look To SBI Rather Than The RBI Or The MPC

One of the big paradoxes of the last 18 months is that it is not the Reserve Bank of India (RBI) or the Monetary Policy Committee (MPC), which are cueing the markets on interest rates, but the big banks, especially State Bank of India (SBI).

In part, this is because the MPC went off track in February 2017, when it prematurely declared a possible end to the rate-cut cycle by announcing a “neutral” policy stance, at a time when inflation was about to fall and banks were flush with post-DeMo cash. It was thus left to the SBI to signal a falling rate regime. It made its moves in July 2017, by cutting deposit rates by 0.5 per cent, and following that up with lending rate cuts in November, and a base rate cut this January.

More recently, a halt to the falling rate cycle was also signalled by the SBI, which raised bulk deposit rates last November, and followed that up this month with a hike in deposit rates by 10-75 basis points (100 basis points make one per cent). The MPC is still to signal higher rates, with five of its six members preferring to wait and watch.

The second reason for the loss of RBI’s signalling role is its own changed priorities. The RBI’s focus is now on ensuring the clean-up of banks’ bad loans. With the unearthing of the Nirav Modi-Punjab National Bank fraud of over Rs 12,700 crore, one could say that banking supervision and fraud prevention are becoming even more important than interest rates.

It was the government which set the ball rolling last year when it amended the RBI Act by inserting two new clauses – sub-section 35AA and 35 AB – to empower the central bank to issue instructions to banks for the resolution of bad loans. This enhanced power changed the RBI’s primary role in the medium term from the conduct of monetary policy to saving the banking system from itself. The RBI duly shifted focus and asked banks to opt for the bankruptcy process to resolve their bad debts problem; more recently, it has abolished all previously available fig-leaves for hiding bad debt: CDR (corporate debt restructuring), SDR (strategic debt restructuring), S4A (sustainable structuring of stressed assets), flexible structuring of existing long-term project loans, and the joint lenders’ forum have all been abolished. Now, the only avenue open to banks is the insolvency court, once defaults become obvious.

This shift in the RBI’s role has also meant a loss of the MPC’s signalling power on rates. When bank balance sheets are stressed, it follows that they are not going to be eager to cut lending rates, since they need a wider spread over the cost of funds to retain margins and provide for bad loans. This means, no matter what the MPC does, public sector banks will be resistant to cutting rates, and will, in fact, use every opportunity to raise them. Private banks will not challenge this since it allows them to obtain even higher spreads over their cost of funds.

Last week, the SBI raised deposit and lending rates. Other banks are quickly following its lead. SBI raised deposit rates by upto 50 basis points, and its lending rate by 20 basis points. SBI’s one-year marginal cost lending rate (MCLR) is now up from 7.95 per cent to 8.15 per cent, which means home buyers and auto loan borrowers will be impacted.

While this is good news for savers and pensioners, borrowers – who are usually corporations and younger people – will start feeling the pinch this year. Since inflation could become a threat in 2018, the trend of increasing interest rates may continue. When interest rates rise, the stock markets usually weaken.

But the interesting point to note is not the rate hike itself, but who is signalling it: it is the SBI. Sometime after demonetisation, a still-wet-behind-the-ears MPC misread the price signals, and failed to see that between them – demonetisation, a good monsoon, and the gross domestic product (GDP) slowdown – will keep inflation low. The shift from an “accommodative” stance to “neutral” was premature. Last year, the RBI needed to cut rates fast, but it did not do so.

SBI stepped into the breach, and the government decided that it would give growth a helping hand by resorting to direct interventions in the loan markets. It offered deep interest subvention schemes for affordable housing, at four per cent on loans for those earning upto Rs 12 lakh, and three per cent for those earning upto Rs 18 lakh. This meant that the most important rate that matters to ordinary people was being determined by fiscal policy, not monetary policy.

Simultaneously, given the trend in bad loans in the banking system, banks have also been moving towards lending more to retail customers rather than corporations. Once again, this re-emphasised the point that the rates are tilted against small and medium companies, and in favour of retail borrowers, who anyway get lower rates. The big companies anyway get lower rates, and don’t need to borrow much from banks.

It is more than likely that the MPC, maybe by June 2018, will formally start raising rates again. At the February meeting, at least one of its six members was already calling for a rate hike, but the recent fall in inflation (January retail inflation was down to 5.07 per cent from 5.21 per cent in December 2018), if it continues, will probably delay the inevitable till June.

Banks’ bad loan problems will, in a sense, also have an impact on lending rates since struggling banks will need higher rates to protect their margins and provide for loan losses. To repeat, it is bank balance sheets, not MPC meetings, that will set the trend in rates.

It will take a while for the RBI and the MPC to re-establish their credibility in setting rates for the economy. If banks are able to resolve the bulk of their bad loan over the next 12 months, it would help. In the near future, it may be more productive to look at what the SBI is doing to rates than what the RBI is doing.

(A part of this article was first written for Dainik Bhaskar)