Explained: Why RBI's repo rate cuts are not enough to bolster GDP growth

Transmission of rate cuts by banks has been slow because any lowering of interest rate, with deposit rates unchanged, will reduce banks' net interest income spread, affecting their revenue.

Business Standard : In order to boost the country’s sagging economy, the Reserve Bank of India’s (RBI’s) monetary policy committee, holding its fifth bimonthly meeting from Dec 3 to 5, is widely expected to again cut the key repo rate by 25 basis points (bps).

Official data released by the government last week showed that India’s gross domestic product (GDP) growth in the July-September quarter of 2019-20 slowed to a 26-quarter low of 4.5 per cent, on a year-on-year basis, for a number of reasons. Weak manufacturing growth, a fall in consumer demand and private investment, and lower exports due to a global slowdown were cited as some of them.

For its part, the RBI has lowered the repo rate — at which commercial banks borrow from it — by a cumulative 135 bps so far this calendar year to 5.15 per cent, the lowest in nine years. Even so, there has been little recovery in the economy during this period. Let’s understand why.

Relation between interest rate and GDP

For any bank, its net interest income (NII) — the difference between the interest it receives on loans given and the interest it pays on deposits — is the main source of its revenue.

A change in lending rate affects the cost of raising funds in the economy. For instance, a cut in lending rate makes loans cheaper. This prompts industrialists to borrow more for, say, capacity expansion (investment), and households for private consumption. This has a direct bearing on the country’s GDP, which, by definition, is the sum total of private consumption, private investment, government investment/spending, and net exports.

However, any cut in banks’ lending rate, should they continue paying interest on deposits at the same rate as before, would reduce their NII spread. That would have a negative impact on their revenues. So, that should explain why banks have shied away from transmitting RBI’s repo rate cuts to borrowers in the form of lending rate cuts.

During its fourth bimonthly review in October, the MPC noted that policy “transmission has remained staggered and incomplete”. In response to a 110-bp cumulative cut in repo, the weighted average lending rate cut on fresh loans had been only 29 bps, it said.