The frequent policy challenge faced by RBI is that of Monetary Policy Transmission. Analysing the reasons for the same, provide solutions. (250 Words)

Mentors Comments:
1. What is monetary policy transmission
2. What are the challenges it faces and why
3. Solutions

Answer:
Monetary transmission refers to the process by which a central bank’s monetary policy signals (like repo rate) are passed on, through financial system to influence the businesses and households. There are many monetary policy signals by the RBI; the most powerful one is the repo rate.

Asymmetry in monetary policy transmission
 Banks find it more difficult to cut lending rates immediately after a cut in the policy rate because the cost of deposits does not adjust commensurately and immediately, given the fixed nature of deposit contracts. However, banks can raise lending rates far more quickly after a policy rate hike, because loans are mostly at variable rates, and can be re-priced faster.
 There is a competitive constraint of reducing deposit rates too much and too quick as well. If bank deposit rates are lower than small savings rates which are administratively fixed, there could be some deposit flight to small savings schemes providing higher returns.

The Reserve Bank of India has been highlighting the problems with the economy’s monetary transmission mechanism for some time now. Some reasons that result in a lag in monetary transmission in India are:
1. Pressure on banks due to locking of funds in government securities (SLR) and cash reserves (CRR). As some funds are already locked in these, banks find it difficult to remain profitable while passing on rate cut benefits.
2. While the banks are not that eager to lend, the demand for credit from corporates also remain low, due to balance sheet concerns, difficulty in acquiring land for fresh green-field projects, low capacity utilisation and lower working capital loan requirement, helped by falling global oil prices.
3. Increasing NPAs in bank balance sheets are one more reason why they cannot quickly pass on rate cuts to users.
4. Just as CRR increases coupled with increase in repo rate reduces liquidity, a decrease in repo rate has to be coupled by decrease in CRR also by RBI, to incentivize banks to increase liquidity in economy.
5. Lack of developed bond markets ensures that most public savings are in Bank deposits, reducing the banks' dependency on repo rate. This in turn reduces the repo rate’s effectiveness in influencing monetary transmission.
6. There is the rather frustrating legacy of administered interest rates, the most prominent of which are the rates on small savings and provident funds.
7. Similarly, the return on provident funds is decided annually by a process that can only be described as political. 

Way forward
The RBI can address this issue by measures to
1. Reduce CRR to induce liquidity in banks
2. Improve bond markets by reducing conditions on banks to purchase govt. bonds, and making the govt. bond market more open as recommended by Urjit Patel Committee.
3. Reduce constraints on bank lending through Priority sector norms.
4. Recommendations by committees headed by Y V Reddy and Shyamala Gopinath that the small savings rate be linked to market rates
5. RBI has told banks to link their interest rates to external benchmarks instead of MCLR to ensure better transmission of monetary policy rates. The options to banks are linking rates to repo rate, the 91-day T-bill yield, the 182-day T-bill yield, or any other benchmark market interest rate produced by the Financial Benchmarks India. 

Given the persistence of rigidities, the RBI needs to take a holistic view of all the factors that might hinder transmission and act in concert with the government to deal with them.

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