Why Interest Rates Aren't Falling

Since February, the Reserve Bank of India (RBI) has aggressively cut the repo rate.

This is the interest rate that the RBI charges the banks when it lends them money. By cutting the repo rate, the RBI has been sending a signal to the rest of the banking system that the lending rates in the system – the interest rates that banks charge from you and me when we take a loan – should come down. This process of repo rate cuts leading to interest rate cuts across the banking system is called “monetary policy transmission”.

The trouble is, in India, this process is rather inefficient. For example, between February and August, the RBI cut repo rate by 110 basis points — 100 basis points make a percentage point — from 6.5% to 5.4%. But, the interest rate charged by banks on fresh loans that they extended during this period fell by just 29 basis points – that is just 27% of the amount by which the repo rate came down.

Frustrated by the sluggish transmission, the RBI decided to cut the repo rate by another 25 basis points in October and urged banks to link their lending rates to the repo rate. Yet, for the most part, the banking system has ignored the signalling and only some banks have reduced lending rates on new loans by 10 basis points. In essence, while the RBI has cut its lending rate to the banks by 135 basis points (or 1.35 percentage points) in the nine months since February, the interest rates being charged to the common consumer this Diwali have come down by only about 40-odd basis points.

Indeed, even though it is counter-intuitive, interest rates on existing loans (not new loans) have actually gone up by 7 basis points.

Why does RBI want lower interest rates?

Since February, India’s economic growth momentum has rapidly decelerated. Projections of GDP growth rate have come down from roughly 7.2%-7.5% in February to 5.8%-6.0%. There are two key problems in the economy and a lower interest rate regime is expected to help in resolving both.