Lag effect of rate rise worries apex bank: Economic Times 28th September 2011

Every time the Reserve Bank of India (RBI) increases interest rates, a plethora of voices are heard. Industry laments that their profits get squeezed affecting growth. Bankers aver that their interest margins come under pressure and non-performing assets (NPAs) get perversely affected. The RBI is concerned more on the transmission mechanism as credit growth continues with only the GSec market being responsive.

At times, bankers openly state that they will not alter rates. What has been the past experience? The increase in repo rate affects banks as they borrow from RBI which affects the call and CBLO markets where the repo rate is the benchmark. Today banks are borrowing around Rs 20,000-50 ,000 crore, while the daily trade volume in the call, CBLO and repo is around Rs 70,000-80 ,000 crore.

The transmission process is quite direct here. Deposits are slow to react to rate hikes, and it is only the incremental deposits which are affected as rates are increased in those tenure buckets where funds are required. Further, a large proportion of deposits (35-40 %) are CASA which buffers the overall cost impact. Now, between FY06 and mid-FY 09 the RBI raised the repo rate by 300 bps, yet the cost of deposits of a set of 71 banks increased from 4.52% to 6.22% with a lag of over a year. Subsequently in FY09, the RBI scaled down the repo rate by 275 bps and later increased the same by 200 bps in the next two years.

Yet, the cost of deposits has been declining continuously from 6.22% in FY09 to 5.54% in FY10 and 5.07% in FY11. Quite clearly, the higher deposit rates of last year have not yet shown in the cost of deposits as there is a lag of 1 year in actual transmission. The return on advances reacts almost instantaneously and the 300-bps increase was reflected in an increase of 230 bps to 10.51% up to FY09. But it declined subsequently even as the RBI raised rates in FY10 and FY11 to 9.28% and 9.24%, respectively.

This really means that banks have not increased their return to retain business. Therefore , a lot depends on the lag effect in FY12 when cost of deposits and return on advances would increase. Net interest margin declined continuously from 3.01% in FY06 to 2.48% in FY10, before increasing to 2.90% in FY11, which means that in net terms, borrowers have started bearing the higher interest cost.

Profitability too has been stable with return on assets vacillating between 0.98% and1.07%. The RBI has maintained that the transmission mechanism of interest rates is sluggish and has, therefore, been aggressive. The return on advances for FY12 would witness an upward thrust with the lag effect of 200-bps increase in rates in the last two years striking harder and faster than that in deposits, especially as the latter slowed down in FY11.

The impact on corporate profits can be gauged by the results of a set of 1,401 non-financial companies. Growth in both PBT and PBIT had accelerated in FY07 (36-38 %) when the RBI increased rates and stabilised at around 27% in FY08 when rates remained unchanged.



Profits declined in FY09 and were robust in FY10 with the base year effect kicking in. However in FY11, growth slowed down to 16-17 %. On asset quality, additions to gross NPAs increased sharply in FY09 (47.8%) and FY10 (33.1%) and moderated subsequently. These were also the years when industrial production slowed down to 2.5% and 5.3%, respectively. The financial crisis had its impact in FY09 when overall GDP growth was impacted.

Therefore, there may be a tendency for NPAs to increase when conditions are challenging and would indirectly be related to interest rates. GSec rates have moved in consonance with the repo rate though with less than unitary elasticity. The yield on 10-years GSec rose by around 50 bps when the repo rate was changed by 125 bps in FY07. The decline in yield by almost 90 bps in FY09 was less than commensurate with the net decrease of 150 bps invoked by the RBI, while the increase in the last two years has again been around half the increase in the repo rate.

Clearly, there are other factors at work affecting the yields. Four conclusions may be drawn. First, the impact on cost of deposits comes with a lag while the cost for borrowers increases immediately. Second, corporate profits have shown some signs of stress last year and will face challenging times in FY12 as fresh investment will be impacted as we have reached the inflexion point.

Third, bank profitability will be under pressure depending on the impact on interest margins and, more importantly, provisions for NPAs. Lastly, the GSec market is the most responsive one and the rates respond , though not commensurately. The story of interest rate impact may just change this year compared with the earlier ones when resilience was shown at all ends.