Why Home Loan Interest Rates Did Not Fall Sufficiently When Raghuram Rajan Cut The Repo Rate

For months, The Reserve Bank of India (RBI) has been criticising major mortgage lenders and commercial banks for not cutting interest rates. RBI Governor Raghuram Rajan had cut the repo rate three times in 2015, by 25 basis points each. When the RBI cut the repo rate in January, major nationalized banks like Union Bank Of India cut the base rate. But, the major mortgage lenders did not. Even when the RBI cut the repo rate further in March 2015, they did not suddenly cut interest rates. But, when the RBI urged them to cut interest rates, they did.

Many analysts see monetary policy transmission as a bigger challenge than cutting the repo rate. Monetary policy transmission, put in simple terms, is the process through which monetary policy decisions of the central bank influence the economy and the price level. The RBI sees the quickness and efficiency with which banks respond to changes in policy rate as a great challenge. In developing countries, monetary policy transmission is seen as less effective. If this is true of India, why is this so? Here are a few reasons.

Repo rate is the rate at which the RBI lends to commercial banks, often against treasury securities. This means that the function of the bond markets have a huge impact on monetary policy transmission in India. But, the RBI has not allowed the bond markets in India to develop in the past twenty five years. Without well-developed bond markets, monetary policy transmission would be less efficient. Many economists suggest that the RBI should establish a public debt management agency (PDMA) and allow the Securities and Exchange Board of India (SEBI) to handle the regulation of bond markets. This would allow the RBI to focus on tackling inflation, because now the RBI monetises the debt of the government through buying government securities. India is likely to have a PDMA by the end of this financial year.

The RBI needs to allow greater competition among banks in India. When the RBI cuts the repo rate, home loan interest rates would decline because of competition among banks to cut interest rates. When a major mortgage lender cuts interest rates, other mortgage lenders would not be able to not cut rates. But, the RBI hands out two banking licenses in a decade and does not allow free competition of foreign banks with Indian banks. As this is so, the impact a change in the repo rate has on home loan interest rates is not as high as it ought to be.

When the RBI cuts the repo rate, for instance, it would lower capital flows and debt flows. This would lead to depreciation of the Indian Rupee, relative to the dollar. But, as the RBI does not allow debt capital flows, monetary policy transmission through the exchange rate is low. As the RBI controls the exchange rate to an extent, monetary policy transmission through the exchange rate is weaker.

An inflation targeting objective that the RBI adopted in March 2015 is expected to lead to more effective monetary policy transmission.