As the mid-quarter monetary policy review due on September 17 draws near, the usual speculation about the Reserve Bank of India’s (RBI’s) action is building up. There is a minority that hopes that the combination of sub-six per cent growth in the last two quarters and somewhat lower-than-expected inflation rates will persuade the RBI to drop the policy rate. The majority in the markets, however, expects no change — particularly in the absence of any visible efforts by the government to pare the fiscal deficit or improve the food-supply situation.
However, in fretting endlessly over whether or not the central bank is likely to cut the policy rate by a minuscule quarter of a percentage point, we tend to forget the fact that the interest rate is ultimately the price of credit — and, like all prices, is determined by its demand and the supply. Thus, to figure out where actual lending and borrowing rates are headed, a quarter of percentage point change in the repo notwithstanding, it is important to get a handle on what the balance between the demand and supply of credit looks like.
At the risk of stating the obvious, let me point out a couple of things. The supply of credit is the available pool of deposits in the banking system, adjusted, of course, for what the RBI takes away in the form of the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR). Of the two, the CRR is really the binding constraint, and the easiest way to influence the supply and hence the price of credit is to push the CRR up or down. Given its potency in managing interest rates, it might not be such a good idea to abolish it after all.
Second, banks make their money from the difference between their cost of deposits and other borrowings and the rate at which they lend. This is the interest margin. As profit-maximising entities accountable to their shareholders, it is rational for them to try and at least protect these margins to the extent possible. The implication is that banks are unlikely to drop lending rates sharply unless they are able to reduce deposit rates. But can they?
A couple of things are important here. First the supply of deposits relative to credit is fairly tight, with the credit-deposit ratio at over 75 per cent. To put this in perspective, it might be useful to look at previous episodes of sharp cuts in deposit rates. In the 2001-2003 period, when banks on average reduced their deposit rates by three and a half percentage points, the credit-deposit ratio was a little less than 55 per cent. A similar reduction took place in the period between 2008 and 2009 when plummeting credit demand (in the wake of the financial crisis of 2008) reduced the credit-deposit ratio by a good five percentage points over a short span of time
This is unlikely to happen this time. Informal surveys of bankers suggest that they are somewhat comfortable with the 17 to 18 per cent rate of credit growth that they see at current lending rates and do not expect this to reduce dramatically. In fact, credit offtake tends to pick up in the second half of the year; come October, the credit-deposit ratio could start moving up again. Add to this a fairly hefty government borrowing calendar (and an overrun in borrowings on the back of a runaway fiscal deficit), and any potential comfort on the liquidity front could just about evaporate. In fact, the RBI might have to step in with both a cut in the CRR and bond purchases from banks (to release rupees) to restore a balance.
What about the longer term? If the deceleration in economic activity continues and GDP growth remains sub-six per cent, it is likely to take a toll on credit demand. These things work with a lag and our estimates suggest that it could take at least six to eight months for weak GDP growth to seep into the credit market. If loan demand loses traction, banks will certainly reduce their effort to mop up deposits and could start lowering deposit rates.
Their response on the lending front might, however, be far more nuanced. For one thing, given slower economic growth and the possibility of delinquency, it might not make sense to hawk more loans by reducing interest rates. This is particularly true for intensely cyclical sectors where creditworthiness is affected the most. I would, for instance, be surprised to see a rate war among banks in the market for truck loans in the middle of a severe economic slowdown. Ditto for things like unsecured personal loans. The sole beneficiaries in terms of interest rates would typically be large, financially stable companies whose cash flows and ability to service loans are relatively protected from the vagaries of the business cycle. As banks make a beeline for these “quality” assets, their rates could come down sharply.
There is another reason why banks might not want to reduce margins by lowering credit rates to expand their loan books. Various estimates including the one released by the RBI in its recent Financial Stability report suggest that non-performing loans are likely to spike in 2013 as repayments of loans to vulnerable sectors like power become due. Banks will have to provide for these bad debts and that will entail a straight hit to their bottom lines. To compensate, they will have to ensure that the profitability on performing loans does not fall; in fact, they could actually want this profitability to increase. Thus, the legroom for drooping margins, and hoping that volume growth in credit somehow compensates for this against the backdrop of falling credit demand, is limited.
Banks also need to raise large amounts of capital to meet their capital requirements especially as the more stringent demand of Basel-III kick in. The RBI’s annual report points out that public sector banks alone will need Rs 1.75 lakh crore of just equity capital to meet Basel-III. This would be impossible to achieve if profitability declines sharply.
The fundamentals of the banking market suggest that we might be stuck in a relatively high-interest rate regime for a while. Small cuts in the repo rate might work wonders for market sentiment but will have only a marginal impact on actual borrowing costs.
The author is chief economist, HDFC Bank