Arbitrary pricing of various money instruments delaying policy transmission: Michael Debabrata Patra


The arbitrary pricing by various players, led by non-banking financiers, in the money markets is delaying the monetary policy transmission, according to Reserve Bank Deputy Governor Michael Debabrata Patra. While other instruments like commercial papers and certificates of deposits also do their part in delaying the policy transmission, the central bank has specifically pinned down NBFCs for the lag, saying unlike banks, “NBFCs, which have a credit portfolio equivalent to about one-fifth of outstanding bank credit, do not follow any uniform methodology for pricing their loans”.

Addressing the treasury heads at a seminar organised by the central bank, Patra said, “While some NBFCs use their own prime lending rates as interest rate benchmarks, others use base rates or MCLRs of banks as external benchmarks. A few of them do not go by any interest rate benchmark at all. This discretionary pricing of spreads undermines monetary policy transmission”.

When it comes to the commercial paper segment, which typically prices off the risk-free rate and issuances are concentrated in maturities of up to three months, with 95 per cent of all issuances in the highest rating category, he said CP rates on instruments of more than three months maturity are highly volatile and unduly influenced by idiosyncratic factors that may not be in sync with the prevailing monetary policy stance.

Furthermore, about 40 per cent of resources mobilised through CPs is by NBFCs, including housing finance companies, which on-lend the funds after adding margins and premiums, thereby hindering the monetary policy transmission.

Similarly, the certificates of deposit (CD) market also has distortions of its own, Patra said, adding “thus, after the monetary policy action and stance gets seamlessly conveyed to the overnight market, the transmission progressively loses strength and sometimes direction as it meanders through the money market spectrum”.

“In recognition of these impediments, central banks are often persuaded to increase the size of their rate changes disproportionately in relation to the desired objective to ensure an adequate amount of transmission, but this can increase borrowing costs inordinately and result in an overkill of economic activity,” the deputy governor who steers the monetary policy department at the Mint Road office said.

In normal times, a policy rate change takes up to one year for its peak impact on growth and up to two years for its peak impact on inflation, he said. These lags in transmission pose an existential dilemma for central banks.

For instance, seeing inflation rising in the future in its forecasts, it raises interest rates. A few months later, the economy begins to slow down. Societal pressures build up on the central bank to support growth and it gives up on inflation control, and price pressures get elevated and go out of control, eventually killing growth.

According to Patra, much of these lags emanate from frictions in financial markets especially in the money, G-Secs, forex and derivatives markets, especially at the synapses.

The impediments to the monetary policy transmission are encountered due to market microstructure as well as the manner in which each segment integrates into the continuum, he noted.

Banks also play a big role in the lags as the bank credit market accounts for nearly half of the total flow of resources to the commercial sector.

“Banks’ practice of changes in deposit rates preceding changes in lending rates and sticky margins have been prime impediments to monetary policy transmission. On the one hand, term deposits are typically contracted at fixed rates.

“When the policy rate changes, term deposits are re-priced at the margin — only in respect of deposits that mature and get renewed and on the other, the mandated linking of lending rates for personal loans and MSME loans directly to external benchmarks, which move in sync with the repo rate is a response to these blockages in the arteries of transmission,” he said.

In its aftermath, there has been a rising preference among banks for external benchmark-linked pricing of loans. This has significantly speeded up transmission and rendered it complete in several categories of fresh loans.

Asset quality, expected loan losses in credit portfolios and sticky small savings interest rates are additional sources of variability in spreads, which highlights the significance of financial system soundness for smoother transmission.

When it comes to the G-Secs market, this is conducive for speedier transmission to the extent that participants anticipate policy actions, the yield curve evolves in a forward-looking manner and macroeconomic developments have a significant role in determining the shape of the yield curve.

In the corporate bond market which uses G-sec yields as benchmarks, only issuers of the highest quality find favour and, as a result, issuers with lower ratings depend on banks. Transmission to corporates across the entire spectrum of ratings, therefore, remains incomplete and/or delayed. The G-sec market’s microstructure also tends to dampen transmission, Patra said.


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