RBI seen cutting rates but your loan rates may not fall

The RBI is being pressured to cut rates when deposits are simply not growing. So how ill banks cut rates when money is in such demand?

Vivek Kaul December 20, 2014 16:40:49 IST
RBI seen cutting rates but your loan rates may not fall

The monetary policy review of the Reserve Bank of India(RBI) is scheduled for today, 19 March. Every time the top brass of the RBI is supposed to meet, calls for interest rate cuts are deafening. In fact, there seems to be a formula that has evolved to create pressure on the RBI to cut the repo rate. The repo rate is the interest rate at which RBI lends to banks and sets the tone for other interest rates.

The formula includes Finance Minister P Chidambaram giving statements in the media about there being enough room for the RBI to cut interest rates. "There is a case for the Reserve Bank of India (RBI) to cut policy rates, and the central bank should take comfort from the government's efforts to cut the fiscal deficit," Chidambaram told the Bloomberg television channel on Monday.

RBI seen cutting rates but your loan rates may not fall

The Reserve Bank of India logo. Reuters

Other than Chidambram, an economist close to Prime Minister Manmohan Singh also gives out similar statements. "The budget has also gone a long way in containing the fiscal deficit, both in the current year and in the following year, and played its role in containing demand pressures in the system. Therefore, in some sense there is greater space for monetary policy now to act in the direction of stimulating growth," C Rangarajan, former RBI governor, who now heads the prime minister's economic advisory council, told The Economic Times.

What Rangarajan meant in simple English was that conditions were ideal for the RBI to cut interest rates.

And then there are bankers (most of them running public sector banks) perpetually egging the RBI to cut interest rates. As an NDTV story points out, "A majority of bankers polled by NDTV expect the Reserve Bank to cut interest rates in the policy review due on Tuesday. 85 percent of bankers polled by NDTV said the central bank is likely to cut repo rates."

Corporates always want lower interest rates and they say that clearly. As a recent Business Standard story pointed out, "An interest rate cut, at a time when demand was not showing any signs of revival, would boost sentiments, especially for interest-rate sensitives like the car and real estate sectors, which had been showing negative growth, a majority of the 15 CEOs polled by Business Standard said."

So everyone wants lower interest rates. The finance minister. The prime minister. The banks. And the corporates.

Lower interest rates will create economic growth is the simple logic. Once the RBI cuts the repo rate, the banks will also pass on the cut to their borrowers. At lower interest rates, people will borrow more. They will buy more homes, cars, two-wheelers, consumer durables and so on. This will help the companies which sell these things. Car sales were down by more than 25 percent in February. Lower interest rates will improve car sales. All this borrowing and spending will revive growth and the economy will grow at higher rate instead of the 4.5 percent it grew at between October and December 2012.

And that's the formula. Those who believe in the formula also like to believe that everything else is in place. The only thing that is missing is lower interest rates. And that can only come about once the RBI starts cutting interest rates. So the question is will RBI Governor D Subbarao oblige?

He may. He may not. But the real answer to the question is, it doesn't really matter.

Repo rate at best is a signal from the RBI to banks. When it cuts the repo rate it is sending out a signal that it expects interest rates to come down in the days to come. Now it is up to banks whether they want to take that signal or not.

When everyone talks about lower interest rates, they basically talk about lower rates on loans that banks give out. Now banks can give out loans at lower interest rates only when they can raise deposits at lower interest rates and that can happen only when there is enough liquidity in the system - i.e. people have enough money going around and they are willing to save that money as deposits with banks.

Let's look at some numbers. In the six-month period between 24 August 2012 and 22 February 2013 (the latest data which is available from the RBI) banks raised deposits worth Rs 2,69,350 crore. During the same period they gave out loans worth Rs 3,94,090 crore. This means the incremental credit-deposit ratio in the last six months for banks has been 146 percent.

So for every Rs 100 that banks have borrowed as a deposit they have given out Rs 146 as a loan in the last six months. If we look at things over the last one-year period, things are a little better. For every Rs 100 that banks have borrowed as a deposit, they have given out Rs 93 as a loan.

What this clearly tells us is that banks have not been able to raise enough deposits to fund their loans. For every Rs 100 that banks borrow, they need to maintain a statutory liquidity ratio of 23 percent. Other than this a cash reserve ratio of 4 percent also needs to be maintained.

So for every Rs 100 that is borrowed by the banks, Rs 27 (Rs 23 + Rs 4) is taken out of the equation immediately. Hence only the remaining Rs 73 (Rs 100 - Rs 27) can be lent. In an ideal scenario the credit-deposit ratio of a bank cannot be more than 73 percent. But over the last six months its been double of that at 146 percent, i.e. banks have loaned out Rs 146 for every Rs 100 that they have raised as a deposit.

So how have banks been financing these loans? This has been done through the extra investments (greater than the required 23 percent) that banks have had in government securities. Banks are selling these government securities and using that money to finance loans beyond deposits.

The broader point is that banks haven't been able to raise enough deposits to keep financing the loans they have been giving out. And in that scenario you can't expect them to cut interest rates on their deposits. If they can't do that, how will they cut interest rates on their loans?

The other point that both Chidambaram and Rangarajan harped on was the government's effort to cut/control the fiscal deficit. The fiscal deficit for the current financial year (ending 31 March 2013) had been targeted at Rs 5,13,590 crore. The final number is expected to come at Rs 5,20,925 crore. So where is the cut/control that Chidambaram and Rangarajan seem to be talking about? Yes, the situation could have been much worse. But simply because the situation did not turn out to be much worse doesn't mean that it has improved.

The fiscal deficit target for the next financial year is at Rs 5,42,499 crore. Again, this is higher than the number last year. When the government borrows more it "crowds out" and leaves a lower amount of savings for the banks and other financial institutions to borrow from. This leads to higher interest rates on deposits.

What does not help the situation is the fact that household savings in India have been falling over the last few years. In the year 2009-10,household savings stood at 25.2 percent of GDP. In the year 2011-12, household savings had fallen to 22.3 percent of GDP. Even within household savings, the amount of money coming into financial savings has been falling. As the Economic Survey that came out before the budget pointed out, "Within households, the share of financial savings vis--vis physical savings has been declining in recent years. Financial savings take the form of bank deposits, life insurance funds, pension and provident funds, shares and debentures, etc. Financial savings accounted for around 55 percent of total household savings during the 1990s. Their share declined to 47 percent in the 2000-10 decade and it was 36 percent in 2011-12. In fact, household financial savings were lower by nearly Rs 90,000 crore in 2011-12 vis--vis 2010-11."

While the household savings number for the current year is not available, the broader trend in savings has been downward. In this scenario interest rates on fixed deposits cannot go down. And given that interest rate on loans cannot go down either.

Of course, bankers understand this but they still make calls for the RBI to cut interest rates. In the case of public sector bankers, the only explanation is that they are trying to toe the government line of wanting lower interest rates.

So whatever the RBI does tomorrow, it doesn't really matter. If it cuts the repo rate, then public sector banks will be forced to announce token cuts in their interest rates as well. On 29 January 2013, the RBI cut its repo rate by 0.25 percent to 7.75 percent. The State Bank of India, the nation's largest bank, followed it up with a base rate cut of 0.05 percent to 9.7 percent the very next day. Base rate is the minimum interest rate that the bank is allowed to charge its customers.

A 0.05 percent cut in interest rate would have probably been somebody's idea of a joke. The irony is that the joke might be about to be repeated in the next few days.

Vivek Kaul is a writer. He tweets @kaul_vivek

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