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India's Broken Interest Rate Transmission

(From my article at Yahoo)

Growth is slowing. At the 5.3% official growth rate, India has grown the slowest in the March quarter in 8 years. Even that is considered suspiciously high, since we are shown a massive growth in exports and subdued imports that no other data point seems to corroborate. The Reserve Bank of India needs to cut rates, say many observers, while fighting for an armchair with yours truly.

RBI controls the rate at which banks can borrow from it, overnight, called the “repo” rate. If they do cut interest rates, how does it impact growth? The traditional answer — when banks can borrow at lower rates from the RBI, they will cut rates for industry and consumers, who will find their loans cheaper and thus make more profits, which will fuel investment and consumption and overall, more growth.

Let us pause for the realists to stop laughing.

In India, this “transmission” of interest rates is broken when rates go down. Bank loans can be at fixed or floating rates — for a fixed rate borrower (such as a car loan) there is no impact of an RBI rate change. For floating rate loans, banks are quick to raise customer interest rates when RBI raises the repo rate. But when RBI cuts rates, banks don’t cut customer rates easily; stating that their cost comes largely from fixed deposits, where they can’t change the interest they pay.

This would be true if their real source of funding was fixed deposits — increasingly, banks fund their costs from low-cost “current account/savings account” deposits, where they pay between zero and four per cent per year today. Secondly, high cost fixed deposits can be converted into floating rate loans through an interest rate swap.

But what if other banks provide cheaper loan rates? Won’t the competition force banks to cut rates? This would be true if customers could easily shift loans to other banks. They can’t, partly due to high prepayment penalties on loans. Typical loans come with a 2% to 4% early payment penalty.

Recently, RBI banned all prepayment penalties for floating rate home loans by banks. But when the National Housing Bank, the regulator for Non Banking Finance Companies like HDFC and LIC Housing Finance had banned such prepayment penalties, they later issued an ominous clarification. Most housing companies had offered loans that were fixed for a few years and then converted to floating rate — the NHB then clarified that such a ban on prepayment penalty would not apply to such “hybrid” loans since the loan was fixed at the time of entry. And then, to be able to levy a penalty, certain financiers introduced a loan that was fixed-rate for 3 months and then reset to a high floating rate. (Ref: Harsh Roongta)

While the ban on penalty would have helped transmit the interest rates down to borrowers, such a ban only applies to a small variety of loans (pure floating rate housing loans). Personal loans, corporate advances and other such loans can have a penalty that restricts borrowers from getting the best interest rate available.

You might say that if loans are floating rate, then they will have to come down anyhow, since loans are now linked to a single “base” rate. Sadly, that is also not true — even “floating rate” loans are connected to the base rate by a spread, of say 2%. Banks tend to retain the same base rate, while attracting new customers with a smaller spread of, say, 1.5%. That means banks will continue to milk existing customers at higher rates while exciting newer customers with a lower one; and existing customers can’t even move because of a penalty.

The other argument is that if banks won’t lend at lower rates, corporates (who have 50% of all bank loans) will go to the bond market instead. This would be true, if India’s bond market wasn’t ridiculously underdeveloped. One reason is that companies that issue bonds in the market need to take care of a much more diverse set of investors, and if they are in trouble, they won’t get much leeway from them. Banks on the other hand are only too keen to restructure loans at the first sight of something going wrong, because that way they don’t have to classify them as a default. Unscrupulous promoters that siphon money out of companies might use this route to have banks fund their lifestyles. While banks need to provision (set aside capital) for a part of restructured assets, RBI even forgives certain instances (like Air India recently), if only to protect the existing set of banks.

How, then, can RBI and the government create a better policy for transmission?

First, create competition. RBI must acknowledge that we have too few banks, and we need a lot more banks. Not 10 more, like they promise and forever leave in abeyance. But 20, 50 or 100. Let’s not restrict the number of banks, just set the criteria for them to exist.

Second, penalize bank loan restructuring. The transmission policy is weaker if banks are the only source of funding. We need to encourage corporates to find other sources of funding and to keep their options open.

Third, encourage the bond and currency markets. The current set of regulations restricts banks from being large players in the exchange traded currency markets. Who can play these markets are further restricted. Foreign investors are discouraged. These things need to change.

Fourth, cut prepayment penalties on small loans. Given the level of derivatives in the market, banks can convert their fixed rate exposure to floating rate to a large extent. It would be better, for transmission, if the RBI restricted all prepayment penalties for all types of loans below Rs. 1 cr. to, say, 0.5%. This is not new; IRDA has disallowed surrender charges on unit-linked insurance products to a maximum of Rs. 6,000.

Lastly, the government must allow companies (and individuals) to declare bankruptcy. In a crisis, too many entities stay in limbo with no capacity to repay. They have to be given protection to let them pick up again, from scratch if necessary. The closure it will provide to banks will also ensure they can finally declare their losses and move on (and if necessary, go bust themselves). The process of creative destruction is well known to us — there is even a Hindu God for it — but we don’t seem to want to let it happen.

We’ll soon move to a regime where RBI will start to drop rates to encourage growth. But it won’t work if their cutting rates will not help the eventual borrowers. And that won’t help growth, the lack of which drives rates cuts in the first place.

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