Dearer money

In less than six months, the banking system has moved from comfortable liquidity to tight liquidity, thanks to oil prices of around $50 per barrel, rising inflation and the consequent monetary tightening.

The bond markets are now setting expectations higher, with the 10-year benchmark paper and another actively-traded 11-year paper shooting decisively past the 7 per cent yield mark. Overnight call rates have crossed 6 per cent and the last three-day repos""the liquidity window provided by the RBI""saw over Rs 4,000 crore of bank bids on November 4.

There is, of course, a gap between what the bond markets are saying and the real action on lending rates. What banks have done so far is to start raising short-term deposit rates, with some of the smaller banks raising rates by as much as 1 percentage point in some deposit slabs up to 90 days.

For maturities above a year, nobody is yet pushing up rates very much, indicating that liquidity worries are currently short-term in nature. Acknowledging this tightening of short-term liquidity, the RBI recently cancelled Rs 2,500 crore worth of auctions under the market stabilisation scheme""a move widely seen as an effort to make sure that forthcoming sales of dated paper do not flop.

The tightening of liquidity has been driven by two parallel, mutually reinforcing, forces: growing demand for funds and market expectations driven by rising inflation. In the first half of FY2005 (March 19""October 15, 2004), total non-food bank credit leapt by a hefty 16.2 per cent (12.1 per cent when adjusted for IDBI's conversion into a bank, which caused a sudden spike).

That's more than twice as much as the growth seen in the corresponding period of 2003-04 (5.9 per cent). A big chunk of this growth came from the sharp growth in retail mortgage lending, with ICICI Bank alone reporting a more than 60 per cent growth in disbursements in the first half up to September 2004.

This rapid growth in non-food credit is, however, as much the result of demand pull as bond market push. As headline inflation rates have gone up steadily this year, bond yields have been rising, too, threatening banks with too much gilts in their portfolio with losses.

This made it increasingly attractive for them to shift funds from government bonds to corporate and retail loans, where the mark-to-market requirements are easier. To protect the government borrowing programme, and also to shield bank balance-sheets, the RBI allowed banks to shift loans to the held-to-maturity category, which banks have taken advantage of in the September quarter.

The stage has now been set for lending rate increases on many fronts. The increase in capital adequacy requirements for home and personal loans is sure to push retail rates up by 25""50 basis points shortly. While prime rates are not set for a general increase, money is already tighter for corporates who were borrowing at sub-PLR rates in easy money conditions.

Banks still have the National Housing Bank and Nabard refinance windows available to raise cheaper funds against home and rural lending, but it is a moot point how long these refinance windows will remain cheap. In the short term, the price of money has only one way to go""and that seems up.