Lack of liquidity forces banks to raise rates; RBI may maintain status quo

State Bank of India’s (SBI’s) continued hikes in deposit rates, three times since January, points to an interesting fact — interest rates have risen in the economy and it would remain that way, irrespective of what the Reserve Bank of India (RBI) decides about its monetary policy rate. 

Analysts expect the central bank to keep its policy rates unchanged on April 5 and also probably for the rest of the calendar year. Ideally, what the central bank does, the commercial banks should follow. But that is hardly the case in the Indian banking system where transmission of policy decisions is a challenge. 

One reason why SBI had to raise rates so frequently is the rapid rise in bond yields, which constitutes the base for calculating deposit and lending rates. Besides, competition was a reason. 

Most other major banks such as Bank of Baroda, ICICI Bank and HDFC Bank also raised their retail and bulk deposit rates, as well as their lending rates, in the past few months. “Others had already increased their rates, and our rates were lower than theirs, so we had to align our rates to the market,” said P K Gupta, managing director of retail and digital banking, SBI. 

It is also a kind of normalisation for the banks. “Rates were cut significantly in the past, and to that extent they are not even close to the highs banks were offering before,” said Karthik Srinivasan, senior director at ICRA. According to Srinivasan, banks could afford to offer lower rates because of huge liquidity after demonetisation. Now, the banks don’t have the same luxury. 

Over the past few months (third and fourth quarter of FY18), several public and private banks have revised both their lending rates and deposit rates; some hiked their rates, while others reduced theirs. 

SBI first raised the interest rate on term deposits in January of this year by 50-140 basis points (bps), and did so again in February, by increasing the interest rate by 25-75 bps, across maturities, including for retail and bulk. This was in response to sharper-than-anticipated bond yield movement. The longer period deposit rates were lower earlier because there was an anticipation that the rates would be lower in the longer run. “Since the yield curve has got steeper and the difference between the one-year bond yield and 10-year bond yield has increased, we have aligned our rates to what is happening in the market,” said Gupta.

When yields rise, a bank’s incremental cost of fund rises too, which forces a bank to increase deposit rates to get more funds. A lending rate hike soon follows, as the bank tries to maintain a spread (its profit) over what it pays for money in order to lend out profitably.

Sure, the bond yields have risen substantially since August, the last time when the RBI cut its policy rates. In the December quarter alone, the 10-year bond yields moved up about 70 bps. In the March quarter though, the yields had a sharp correction after the announcement of lower-than-expected first-half borrowing numbers. 

There are many reasons for the bond yields to rise, but the primary reason is the quick disappearance of abundant liquidity from the system, prompted by aggressive liquidity mop-up by the central bank. 

The liquidity deficit, as of March 27, was Rs 671.79 billion. This was because of the advance tax outflow at the end of the year and also because the government was not spending enough. 

Normalisation of cash availability in the system has also drained liquidity from the system. As of March 9, the currency in circulation stood at Rs 18.13 trillion, higher than the Rs 17.97 trillion worth of currency in circulation at the time of demonetisation.

The liquidity will improve when the government starts spending in the new financial year, but the central bank’s official stance is to keep the liquidity in neutral territory. Till such time, the pressure on yields will continue and so will the rates pressure on banks.