Why bank on RBI’s rate change? Mint: 22nd October 2009

If commercial lenders reduce intermediation costs, they can cut lending rates. RBI should consider that Since there is general agreement in India’s macroeconomic circles that inflation will increase, the logical corollary is to conjecture the Reserve Bank of India’s (RBI) view on interest rates. Apologists for industry are warning that any increase in interest rates could hamper industrial recovery, as had happened in the past. But before we jump to that conclusion, the positions of the four constituents in this matter—RBI, banks, borrowers and deposit holders—need to be considered.Last year, RBI intervened as many as 11 times with the cash reserve ratio (the portion of deposits each bank keeps as reserves), nine times with the repo rate (to inject liquidity into the system) and five times with the reverse repo rate (to absorb liquidity from the system). To begin with, it increased these rates initially to counter what was agreed to be cost-push inflation—one caused by a decrease in aggregate supply, and hence an increase in prices of goods and services—and then lowered the rates to spur growth as part of the government’s stimulus package in the wake of the slowdown. Inflation today is still a supply-driven phenomenon, but RBI has to brace up to ensure that such a situation does not snowball into a demand-pull inflation scenario—one caused by an increase in aggregate demand relative to supply that the central bank can influence more easily. Hence, it may embark on increasing interest rates.Prima facie, the view that higher rates will affect industrial investment and production may be an overstatement since interest costs as a percentage of total expenses is quite low; in fact, it has declined from 5.1% in fiscal 2000 to 2.7% in fiscal 2009, according to data from the Centre for Monitoring Indian Economy. The overall business environment rather than borrowing costs is more likely to be the clinching factor for investment decisions.This view is supported in Table 1, where prime lending rates (PLRs) have been juxtaposed with growth in credit. Growth in credit in fiscal 2007 was buoyant despite higher rates, while the expected pattern was not witnessed in fiscal 2001, 2002, 2006 and 2009. Interest rates may be the clinching factor at the margin in case of mortgages or auto loans in the retail segment—but the capital cost of the dwelling or vehicle may still matter more.Households could feel some relief if interest rates on deposits are increased as they earn a negative real return on deposits at present —with inflation, as measured by consumer price indices, exceeding 10% (the real rate equals the nominal rate minus inflation)—and as they are at present not organized to lobby for higher rates. Yet, banks have always argued that they cannot alter deposit rates in the face of state-administered interest rates on small savings, which are high. And, they say, if they can’t change the deposit rate, they can’t change their lending rates. However, this does not always hold, as seen in fiscal 2002 (Table 1).The solution really lies in the operations of banks. Banks perform the function of intermediation and take deposits from the public and bear the risk of lending the money. Can there be any benchmark for the cost of intermediation where the interests of deposit holders and borrowers are matched?The behaviour of banks in the last decade sheds some light. To begin with, they have been free to determine their interest rates ever since India went in for deregulation in 1994-95. However, the repo rate has still served as the benchmark, without good reason. The average quantum of borrowings from RBI through the repo or reverse repo windows has not exceeded Rs30,000 crore a day. Given that incremental credit in a year is in the region around Rs5 trillion, the relatively low levels of repo borrowings should not be significant.Table 1 shows that banks have tended to adjust their rates in a differential manner. In eight of the 10 years, deposit rates have moved in accordance with changes in the repo rate, while lending rates have followed suit in only five. In fact, in fiscal 2010, the deposit rate has come down by 1.5 percentage points while PLR has decreased by 0.5 percentage point. Can lending rates not respond faster?The table also shows that banks have been working on a relatively high spread (difference between PLR and deposit rate), which has increased from as low as 2.5% in fiscal 2001 to 7% in fiscal 2004. There is potential for banks to actually operate on lower spreads— considering that they are in the region of 1-2.5% globally.While the intermediation spread captures the macro picture, Table 2 provides the actual spread of banks, defined as excess of returns over cost of funds. The variation is quite stark out here: Foreign banks have exceptionally high spreads, followed by private banks and then public sector banks. The difference can be attributed to the composition of loans, with some banks focusing more on cards, automobiles and personal segments, where rates are higher. Public sector banks have more moderate spreads, as there is a commitment to the priority sector, where PLR easily becomes the benchmark.The message clearly is that we need to reduce intermediation costs to strike a balance. Banks complain that they have limited manoeuvrability to lower lending rates, which is perhaps an excuse.