It seems almost a certainty that RBI will lower rates on April 5, the first policy review for the new fiscal. The reason is quite straight forward.
It seems almost a certainty that RBI will lower rates on April 5, the first policy review for the new fiscal. The reason is quite straight forward. The government had asked RBI in form of ‘advice’, to lower rates after the Budget where the net borrowing programme projected was lower than that of last year. Also RBI had mentioned in February policy that it would be looking closely at the impact of the budget, especially the borrowing programme before taking a call on interest rates and the government has addressed this issue adequately.
Second, inflation is within RBI’s range of 6% in January 2016 and 5% in FY17. The number of 5.2% which is down from 5.7% in January can be interpreted either ways with a tilt to decrease rates to spur the economy. Third, the central bank has been arguing that there was a dichotomy in interest rates on small savings and bank deposits which made monetary policy transmission weak. This too has been addressed by the government recently and hence a window has opened once again to further the case for a rate cut.
Fourth, the corporate sector has been asking for rates to be brought down as investment decisions have been deferred on this score. Fifth, the market wants rates to come down, which has become more of a habit now. In fact, to drive home the point, the market is talking of 50 bps cut, hoping that at least 25 bps will materialise. Therefore, there is strong case for conjectures to point in this direction.
At present, the debate is on the quantum of rate cut. Anything less than 50 bps will be a disappointment as it will be considered to be ineffective. A curious development is that this year, while central government borrowing will be under check, state government’s borrowings can be the joker in the pack as the UDAY scheme could entail additional state development loans (SDL) entering the market which can cause interest rates to move up. Intuitively, more paper in the market increase supply and lowers prices which translates to higher yields. Given that they are offering higher rates, there could be a temptation as these securities can come under held-to-maturity (HTM) category. Therefore, the course taken by the securities market will be interesting this year.
Given that interest rates will be reduced, the next question is what will be the impact. The transmission issue has probably been addressed by the soon to be introduced marginal costing method. Assuming this transpires, base lending rates will come down while deposit rates would most certainly be reduced immediately. This time lag is understandable as deposits get re-priced on incremental basis while all lending gets re-priced at lower rates, which affects bank earnings.
Two issues stand out. The first is whether banks will be keen to lower rates on lending or lend more funds. At present, they operate with a spread of 3-4% which is one of the highest in the world and banks may prefer to maintain it. Further, the PSBs are inundated with NPAs ,mainly in the sectors that are looking for funding like infrastructure and manufacturing. Unlike the PSBs, the private banks have a different profile with more focus on retail and services sectors. Hence, the question raised is whether these banks will be willing to get into the riskier ventures and concomitantly, whether the PSBs will continue lending to them. Now, most certainly, the lending rates may not come down as long as the credit risk perception and premium is high. Therefore, willingness to lend will be an issue for banks. Add to this the fact that these banks are challenged for capital and there will be further hesitation in lending.
Second, the more important issue is the demand for credit, a factor which has been ignored in this argument for lower rates. While there have been phases when corporates have sought commercial paper or bonds when the transmission was tardy, in general, demand has been low from manufacturing and non-financial services. This being the case, demand can be an issue, especially during the first half of the year, considered a lean or slack season. Also, the latest RBI data shows that the capacity utilisation rates around 70% are still quite low and may not generate any urgency on part of corporates to borrow funds.
Therefore, the demand for funds may be sluggish with supply also trickling especially from the PSBs. Banks could just pitch for more government securities and add to the excess SLR.This has been the problem even in developed economies that have pursued aggressive policies of keeping interest rates close to zero for long as well as supplying large doses of liquidity. Demand for funds did not pick up given sluggish economic conditions. Under these conditions the elasticity of demand for funds would tend to be very low, which appears to be the case in India. Thus, while government has cleared several projects, they have not taken off in a big way to pressurise the financial system.
One repercussion of rate cuts however would be on savings. RBI has spoken of a real interest rate of 1.5-2%. At present, it appears that the differential between repo rate and inflation is 1.75% and if inflation remains unchanged, any reduction in repo rate will bring real rates down further. The impact on savings will be perceptible given that returns will be falling on all instruments now. A possible consequence can be movement to real estate which will be useful at macro level; or gold which can create problems. The gold bond scheme has not quite enthused households.
RBI decision on interest rates becomes more important today given these conflicting emotions. The question is whether or not RBI will move towards placating the corporate sector and markets and hence lay the ground for further cuts in future when demand for funds picks up. The answer looks to be in the affirmative. Will this lead to an increase in credit offtake? The answer, at best, is a shrug as banks may not be too willing while demand may also be subdued. The only reason for a contrary decision, i.e., to take a pause is the news of unseasonal rains harming the rabi crop. But that would only mean deferring a decision rather than taking a stance.
It seems almost a certainty that RBI will lower rates on April 5, the first policy review for the new fiscal. The reason is quite straight forward. The government had asked RBI in form of ‘advice’, to lower rates after the Budget where the net borrowing programme projected was lower than that of last year. Also RBI had mentioned in February policy that it would be looking closely at the impact of the budget, especially the borrowing programme before taking a call on interest rates and the government has addressed this issue adequately.
Second, inflation is within RBI’s range of 6% in January 2016 and 5% in FY17. The number of 5.2% which is down from 5.7% in January can be interpreted either ways with a tilt to decrease rates to spur the economy. Third, the central bank has been arguing that there was a dichotomy in interest rates on small savings and bank deposits which made monetary policy transmission weak. This too has been addressed by the government recently and hence a window has opened once again to further the case for a rate cut.
Fourth, the corporate sector has been asking for rates to be brought down as investment decisions have been deferred on this score. Fifth, the market wants rates to come down, which has become more of a habit now. In fact, to drive home the point, the market is talking of 50 bps cut, hoping that at least 25 bps will materialise. Therefore, there is strong case for conjectures to point in this direction.
At present, the debate is on the quantum of rate cut. Anything less than 50 bps will be a disappointment as it will be considered to be ineffective. A curious development is that this year, while central government borrowing will be under check, state government’s borrowings can be the joker in the pack as the UDAY scheme could entail additional state development loans (SDL) entering the market which can cause interest rates to move up. Intuitively, more paper in the market increase supply and lowers prices which translates to higher yields. Given that they are offering higher rates, there could be a temptation as these securities can come under held-to-maturity (HTM) category. Therefore, the course taken by the securities market will be interesting this year.
Given that interest rates will be reduced, the next question is what will be the impact. The transmission issue has probably been addressed by the soon to be introduced marginal costing method. Assuming this transpires, base lending rates will come down while deposit rates would most certainly be reduced immediately. This time lag is understandable as deposits get re-priced on incremental basis while all lending gets re-priced at lower rates, which affects bank earnings.
Two issues stand out. The first is whether banks will be keen to lower rates on lending or lend more funds. At present, they operate with a spread of 3-4% which is one of the highest in the world and banks may prefer to maintain it. Further, the PSBs are inundated with NPAs ,mainly in the sectors that are looking for funding like infrastructure and manufacturing. Unlike the PSBs, the private banks have a different profile with more focus on retail and services sectors. Hence, the question raised is whether these banks will be willing to get into the riskier ventures and concomitantly, whether the PSBs will continue lending to them. Now, most certainly, the lending rates may not come down as long as the credit risk perception and premium is high. Therefore, willingness to lend will be an issue for banks. Add to this the fact that these banks are challenged for capital and there will be further hesitation in lending.
Second, the more important issue is the demand for credit, a factor which has been ignored in this argument for lower rates. While there have been phases when corporates have sought commercial paper or bonds when the transmission was tardy, in general, demand has been low from manufacturing and non-financial services. This being the case, demand can be an issue, especially during the first half of the year, considered a lean or slack season. Also, the latest RBI data shows that the capacity utilisation rates around 70% are still quite low and may not generate any urgency on part of corporates to borrow funds.
Therefore, the demand for funds may be sluggish with supply also trickling especially from the PSBs. Banks could just pitch for more government securities and add to the excess SLR.This has been the problem even in developed economies that have pursued aggressive policies of keeping interest rates close to zero for long as well as supplying large doses of liquidity. Demand for funds did not pick up given sluggish economic conditions. Under these conditions the elasticity of demand for funds would tend to be very low, which appears to be the case in India. Thus, while government has cleared several projects, they have not taken off in a big way to pressurise the financial system.
One repercussion of rate cuts however would be on savings. RBI has spoken of a real interest rate of 1.5-2%. At present, it appears that the differential between repo rate and inflation is 1.75% and if inflation remains unchanged, any reduction in repo rate will bring real rates down further. The impact on savings will be perceptible given that returns will be falling on all instruments now. A possible consequence can be movement to real estate which will be useful at macro level; or gold which can create problems. The gold bond scheme has not quite enthused households.
RBI decision on interest rates becomes more important today given these conflicting emotions. The question is whether or not RBI will move towards placating the corporate sector and markets and hence lay the ground for further cuts in future when demand for funds picks up. The answer looks to be in the affirmative. Will this lead to an increase in credit offtake? The answer, at best, is a shrug as banks may not be too willing while demand may also be subdued. The only reason for a contrary decision, i.e., to take a pause is the news of unseasonal rains harming the rabi crop. But that would only mean deferring a decision rather than taking a stance.
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