GS Notes

6. Economics Notes 08

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Elaborate Notes

Bond Maturity and Bond Yield

  • Bond Yield and Maturity Relationship: The relationship between the yield (rate of return) of a bond and its time to maturity is graphically represented by a yield curve. In a normal economic environment, the yield curve is upward sloping. This is known as a Normal Yield Curve.
    • Rationale: Long-term bonds typically offer higher yields than short-term bonds. This is to compensate investors for several risks associated with holding a debt instrument for a longer period. These risks include:
      1. Inflation Risk: The risk that future inflation will erode the purchasing power of the bond’s fixed payments.
      2. Interest Rate Risk: The risk that market interest rates will rise, making the existing bond with its lower fixed coupon rate less attractive, thereby decreasing its market price.
      3. Opportunity Cost: Locking money for a longer duration prevents the investor from taking advantage of other potentially more lucrative investment opportunities that may arise.
  • Economic Context (COVID-19 Pandemic): During the COVID-19 pandemic, economies globally experienced a severe slowdown. In India, this manifested as falling aggregate demand, reduced consumption, widespread job losses, and supply chain disruptions. The Reserve Bank of India (RBI) responded by adopting an accommodative monetary policy, which involved reducing the Repo Rate. The objective was to encourage banks to lower their lending rates, thereby making credit cheaper for businesses and consumers to stimulate investment and consumption. This process is known as monetary policy transmission.
  • Inappropriate Monetary Transmission: Despite RBI’s reduction of the Repo Rate, commercial banks were reluctant to pass on the full benefit to the end borrowers, especially for long-term loans like home loans and auto loans. This sluggish or incomplete pass-through from the policy rate to lending rates is termed ‘inappropriate’ or ‘incomplete monetary transmission’. The yield on long-term government securities, which acts as a benchmark for long-term loans, remained high, making such loans costly.

Operation Twist

  • Objective: The primary goal of Operation Twist is to manage the yield curve, specifically to lower the yields on long-term bonds while simultaneously raising yields on short-term bonds, without altering the overall money supply. The aim in the Indian context was to make long-term loans (e.g., for housing, automobiles, infrastructure) cheaper to boost demand.
  • Mechanism: Operation Twist involves the central bank (RBI) conducting simultaneous open market operations (OMOs):
    1. Buying Long-Term Government Securities (G-Secs): The RBI purchases long-term G-Secs (e.g., with a 10-year maturity) from the secondary market. This action increases the demand for these bonds. According to the basic principles of supply and demand, an increase in demand leads to an increase in the price of the bond.
    2. Selling Short-Term Government Securities: Simultaneously, the RBI sells an equivalent amount of short-term G-Secs (e.g., with a maturity of less than one year) in the market. This increases the supply of short-term bonds, causing their prices to fall.
  • Impact on Yield: Bond prices and bond yields have an inverse relationship.
    • When RBI buys long-term bonds, their prices rise, and consequently, their yields fall. A lower yield on benchmark long-term G-Secs signals to the market that the cost of long-term borrowing should decrease, prompting banks to lower interest rates on loans like home loans.
    • When RBI sells short-term bonds, their prices fall, and their yields rise.
  • Historical Context: The term “Operation Twist” was coined to describe a policy implemented by the U.S. Federal Reserve in 1961 under the Kennedy administration. The goal then was to strengthen the U.S. dollar and stimulate the economy by lowering long-term interest rates while keeping short-term rates high. RBI first announced its version of Operation Twist in December 2019.

Monetary Transmission Mechanism

  • Definition: The Monetary Transmission Mechanism (MTM) is the process through which a central bank’s monetary policy actions, such as changes in the policy rate (Repo Rate), are transmitted through the financial system to influence key macroeconomic variables like inflation, consumption, and investment. A weak or inefficient MTM hinders the effectiveness of monetary policy.
  • Evolution of Lending Rate Benchmarks in India: Since the deregulation of interest rates on advances above ₹2 lakhs in 1994, RBI has progressively refined the framework for determining lending rates to improve monetary transmission.
    1. Benchmark Prime Lending Rate (BPLR): (Until June 2010)
    2. Base Rate: (July 2010 - March 2016)
    3. Marginal Cost of Funds based Lending Rate (MCLR): (April 2016 - September 2019)
    4. External Benchmark Lending Rate (EBLR): (From October 2019)

Internal Benchmark Lending Rate Regimes

  • Benchmark Prime Lending Rate (BPLR):
    • Concept: BPLR was the interest rate that commercial banks charged their most creditworthy, or “prime,” customers, typically large corporations.
    • Flaws: The BPLR system was highly opaque. Banks often lent to large corporate clients at rates sub-BPLR (below the declared benchmark), which constituted nearly 70% of total credit. To compensate for the lower margins on corporate loans, banks charged higher interest rates to retail customers and Small and Medium Enterprises (SMEs). This cross-subsidization distorted the credit market and severely hampered monetary transmission, as changes in the Repo Rate had little to no effect on the actual lending rates for the majority of borrowers.
  • Base Rate System (2010):
    • Concept: Introduced to replace the flawed BPLR, the Base Rate was the minimum interest rate below which banks were not permitted to lend, with certain exceptions like agricultural loans.
    • Calculation: It was an internal benchmark calculated based on four components: (a) average cost of funds, (b) operating expenses, (c) minimum margin or profit, and (d) cost of maintaining the Cash Reserve Ratio (CRR).
    • Failure of Transmission: The Base Rate system also failed to ensure swift monetary transmission due to several structural issues and arguments put forth by banks:
      1. Use of Average Cost of Funds: Banks calculated the Base Rate using the historical average cost of their deposits, not the current or marginal cost. Since deposits are of varying tenors, a change in the Repo Rate today would take a very long time to reflect in the average cost, leading to a significant lag in transmission.
      2. Bank-Specific Factors: Banks’ profitability, particularly rising Non-Performing Assets (NPAs), influenced their decision to change rates. Banks with high NPAs were reluctant to lower lending rates to protect their profit margins.
      3. Twin Balance Sheet Problem: This term, highlighted by the Economic Survey 2016-17 (authored under CEA Arvind Subramanian), refers to the stressed balance sheets of both the corporate sector (over-leveraged and unable to pay back loans) and the banking sector (burdened with high NPAs). This created a vicious cycle where stressed companies couldn’t invest, and stressed banks couldn’t lend, crippling economic growth.
      4. Double Financial Repression: Banks argued they were financially “repressed” on both sides of their balance sheet.
        • Asset Side Repression: High mandatory holdings of government securities (Statutory Liquidity Ratio - SLR) and targets for Priority Sector Lending (PSL) (40% of Adjusted Net Bank Credit) at concessional rates limited their ability to lend to more profitable sectors. Frequent farm loan waivers by governments further eroded their asset quality.
        • Liability Side Repression: Competition from government-run small savings schemes like the Sukanya Samriddhi Yojana and Public Provident Fund (PPF), which offered high, administered interest rates, forced banks to keep their deposit rates high to attract funds. This increased their cost of funds.

Marginal Cost of Funds Based Lending Rate (MCLR) (2016)

  • Concept: Introduced to address the shortcomings of the Base Rate, MCLR was also an internal benchmark but was designed to be more sensitive to changes in the policy rate.
  • Calculation: Its key innovation was the use of the marginal cost of funds instead of the average cost.
    • Marginal Cost of Funds: The cost incurred by the bank to arrange one additional unit of fund; i.e., the interest rate on the newest deposits and borrowings. This is more sensitive to current interest rate changes, including the Repo Rate.
    • Other components included: (b) Negative carry on account of CRR, (c) Operating Costs, and (d) Tenor Premium (an additional charge for the higher risk associated with longer-term loans).
  • Reasons for Introduction: The Dr. Janak Raj Committee studied the MCLR system and found that while it was an improvement over the Base Rate, transmission was still not fully effective. The internal calculation method still gave banks some discretion to delay the pass-through of policy rate changes.

External Benchmark Lending Rate (EBLR) (2019)

  • Concept: To enforce complete transparency and faster transmission, RBI mandated all new floating rate retail loans (like home, auto) and loans to MSMEs to be linked to an external benchmark, effective from October 1, 2019.
  • External Benchmarks: Unlike previous systems where the benchmark was calculated internally by each bank, RBI provided four external, market-determined options:
    1. RBI’s policy Repo Rate
    2. Government of India 91-day Treasury Bill yield
    3. Government of India 182-day Treasury Bill yield
    4. Any other benchmark market interest rate published by Financial Benchmarks India Pvt. Ltd. (FBIL).
  • This shift makes the transmission direct and immediate. When RBI changes the Repo Rate, the lending rates linked to it change automatically.
  • Context of Federal Tightening: When the US Federal Reserve engages in “federal tightening,” it raises its policy interest rates. This makes US government bonds more attractive, offering higher yields. As a result, Foreign Institutional Investors (FIIs) may sell their investments in emerging markets like India and move their capital to the US. This “flight of capital” increases the demand for US dollars and reduces its supply in India, causing the Indian Rupee to depreciate. A weaker rupee makes imports (like crude oil, fertilizers) costlier, leading to cost-push inflation. In such a scenario, RBI’s Monetary Policy Committee (MPC) faces a dilemma. Cutting the Repo Rate to boost domestic growth could exacerbate inflation and capital outflows, so it may choose to hold or even raise rates, despite a domestic slowdown.

Treasury Bills (T-Bills)

  • Definition: T-Bills are short-term debt instruments issued by the Government of India to meet its short-term funding requirements. They are a part of the money market, which deals with financial instruments with a maturity of less than one year.
  • Issuer: T-Bills are issued only by the Central Government. RBI conducts the auctions on its behalf. State governments do not issue T-bills; they issue State Development Loans (SDLs).
  • Features:
    • Maturity: They are currently issued in three tenors: 91 days, 182 days, and 364 days. (A 14-day T-Bill was discontinued).
    • Zero-Coupon Bonds: T-Bills do not carry a coupon or pay periodic interest. They are therefore also known as Zero-Coupon Securities.
    • Issued at a Discount: They are sold at a price lower than their face value (discounted price) and are redeemed at their face value upon maturity. The difference between the issue price and the face value represents the investor’s return. For example, a 91-day T-Bill with a face value of ₹100 might be issued at ₹98. The investor pays ₹98 and receives ₹100 after 91 days, with the ₹2 difference being the interest earned.
    • SLR Eligibility: T-Bills are eligible securities for banks to meet their Statutory Liquidity Ratio (SLR) requirements.

Prelims Pointers

  • Normal Yield Curve: An upward-sloping curve where long-term debt instruments have a higher yield than short-term ones.
  • Operation Twist: Simultaneous buying of long-term government securities and selling of short-term securities by the central bank.
  • Objective of Operation Twist: To lower long-term interest rates (yields) and raise short-term rates.
  • Origin of Operation Twist: First used by the U.S. Federal Reserve in 1961.
  • Monetary Transmission: The process by which a central bank’s policy rate changes affect interest rates in the broader economy.
  • BPLR: Benchmark Prime Lending Rate; used till June 2010. It was an opaque system leading to sub-BPLR lending.
  • Base Rate: Introduced in July 2010; the minimum rate for lending, calculated on the average cost of funds.
  • MCLR: Marginal Cost of Funds based Lending Rate; introduced in April 2016. It is based on the marginal (latest) cost of funds.
  • EBLR: External Benchmark Lending Rate; mandatory for new floating rate retail loans from October 1, 2019.
  • External Benchmark Options: 1. Repo Rate, 2. 91-day T-Bill yield, 3. 182-day T-Bill yield, 4. Any other FBIL-published rate.
  • Twin Balance Sheet Problem: Stressed balance sheets of both the corporate sector (overleveraged) and the banking sector (high NPAs). Term prominently used in Economic Survey 2016-17.
  • Double Financial Repression: Banks facing constraints on both asset side (PSL, SLR) and liability side (competition from small savings schemes).
  • Treasury Bills (T-Bills): Short-term money market instruments issued by the Central Government only.
  • T-Bill Tenors: Currently issued for 91 days, 182 days, and 364 days.
  • T-Bill Characteristics: They are Zero-Coupon Bonds, issued at a discount and redeemed at face value.
  • G-Secs vs T-Bills: G-Secs are long-term instruments issued by both Central and State governments, while T-Bills are short-term and issued by the Central government only.

Mains Insights

1. Evolution of Monetary Policy Transmission as a Continuous Reform Process (GS Paper III)

  • Problem Statement: One of the most persistent challenges for the RBI has been ensuring effective and swift monetary policy transmission. The journey from BPLR to EBLR reflects a trial-and-error approach to fix this structural issue.
  • Cause-Effect Analysis:
    • BPLR Regime: The cause was lack of transparency and discretion given to banks. The effect was the cross-subsidization of corporate loans at the expense of retail borrowers and negligible policy transmission.
    • Base Rate Regime: The cause of failure was the use of ‘average’ cost of funds and banks’ reluctance to lower rates due to high NPAs (Twin Balance Sheet problem). The effect was delayed and incomplete transmission.
    • MCLR Regime: The shift to ‘marginal’ cost was an improvement, but it remained an internal benchmark, allowing banks some leeway. Transmission improved but was not instantaneous.
    • EBLR Regime: This represents a paradigm shift from internal to external benchmarks. It enforces transparency and ensures a direct and immediate pass-through of policy rate changes, at least for new loans. This is the RBI’s most decisive step to resolve the transmission puzzle.
  • Debate: While EBLR improves transmission, it also exposes banks and borrowers to more frequent interest rate volatility. For banks, it can create an asset-liability mismatch if their deposit rates (liability side) do not move in sync with their loan rates (asset side).

2. Unconventional Monetary Policy Tools and their Relevance (GS Paper III)

  • Context: In situations where conventional tools like the Repo Rate cut are ineffective due to poor transmission, the central bank may resort to unconventional tools like Operation Twist.
  • Analysis of Operation Twist:
    • Pros: It is a targeted intervention to influence the yield curve without injecting net liquidity into the system (it’s liquidity neutral). It can effectively reduce the cost of long-term borrowing, which is crucial for reviving investment in sectors like housing and infrastructure.
    • Cons/Limitations: Its effectiveness may be limited if the reasons for high long-term rates are structural (e.g., high fiscal deficit, inflation expectations) rather than just market sentiment. It can also be seen as distorting the market’s price discovery mechanism for long-term bonds.

3. The Trilemma of Monetary Policy in an Interconnected World (GS Paper III)

  • Concept: The concept of ‘Federal Tightening’ highlights the constraints on India’s monetary policy. Indian policymakers often face a trilemma (or a dilemma) in choosing between controlling inflation, stimulating growth, and managing external stability (exchange rate).
  • Analytical Perspective:
    • A decision by the US Fed to raise interest rates can trigger capital outflows from India, causing rupee depreciation and imported inflation.
    • In this scenario, if the RBI cuts its repo rate to support domestic growth, it could worsen capital flight and inflation.
    • If the RBI raises rates to defend the rupee and control inflation, it could choke off domestic recovery.
    • This demonstrates that India’s monetary policy cannot be formulated in isolation and is heavily influenced by the actions of major global central banks, particularly the US Federal Reserve. This constrains the MPC’s ability to focus solely on domestic inflation and growth targets.

4. Banking Sector Health and its Macroeconomic Linkages (GS Paper III)

  • Interlinkage: The discussion on poor transmission reveals the deep connection between the health of the banking sector and the effectiveness of macroeconomic policy.
  • Historiographical Viewpoint: The issues of Twin Balance Sheet Syndrome and Double Financial Repression are not just technical problems; they are symptomatic of deeper structural issues in the Indian economy. The Economic Survey 2016-17, under CEA Arvind Subramanian, provided a powerful analytical framework to understand the TBS problem. Similarly, the recommendations of various committees, from Narasimham Committee (1991, 1998) advocating for interest rate deregulation to the Dr. Urjit Patel Committee (2014) pushing for a more robust MTM, have shaped the reform trajectory. The failure of monetary transmission is, therefore, a direct consequence of unresolved banking sector issues, necessitating comprehensive reforms beyond just changing benchmark formulas.

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