So, if we bring down our prime rate, automatically earnings on such mandated loans will go down. But if we do not bring down our prime rate, we won’t need to compromise on our earnings from such loans. At the same time, we have the flexibility of offering loans at below prime rates to the good customers.
Borrower: I see… Again, a structural issue. But why are the bond yields going up despite the rate cut?
Banker: This is because of over-supply of bonds. The government is flooding the market with bonds but banks don’t have the appetite for such a large government borrowing programme. Naturally, the prices will go down and yields will go up.
The situation will get worse next year. The central bank has been trying hard to maintain stability in the market. It is, in fact, buying bonds but unless the government starts privately placing bonds with the regulator, the sentiment won’t improve.
Borrower: What prevents the government from privately placing bonds with the regulator?
Banker: Private placement of bonds with the central bank amounts to monetization of fiscal deficit. Under the Fiscal Responsibility and Budget Management (FRBM) Act, monetization is not allowed unless the government admits that there is a crisis. It also needs the nod of Parliament. Probably this will happen after a new government takes over in June.
Once RBI starts printing money, the pressure on the bond market will ease but we will run the risk of fuelling inflation. But I guess when inflation is dramatically coming down, this is an ideal solution.
Borrower: Can RBI do anything else to bring down the rates? Say, cutting down the policy rate further?
Banker: It’s difficult. It has brought down its repo rate ,or the rate at which it infuses liquidity in the system, to 5%. And the reverse repo rate, or the rate at which it sucks out liquidity, is now 3.5%. Since the mandated savings bank rate is 3.5%, RBI will not be able to bring down its reverse repo rate further as it cannot have a policy rate lower than the rate banks offer on savings deposits. In that sense, a 3.5% policy rate in India is equivalent to zero in the US. Unless the savings rate is brought down, RBI will not be able to cut its reverse repo rate.
Borrower: Can the savings bank rate be brought down?
Banker: It’s highly unlikely at this point. It’s a political issue as millions of depositors are involved. RBI cannot go ahead on this without the government’s nod. It can happen when a new government takes over after the elections.
Borrower: Does this mean there won’t be any more rate cut?
Banker: I am not saying so. RBI can cut its repo rate and bridge the gap between repo and reverse repo rates, which is one and a half percentage points now.
Borrower: Will that help?
Banker: Hardly. Theoretically, the rate in the overnight call money market— from where banks borrow to tide over temporary asset-liability mismatches— should move in the corridor between repo and reverse repo rates. If the corridor shrinks, the volatility in the overnight call money rates will diminish. But with plenty of liquidity in the system, call money is moving at the lower end of the corridor and there is no volatility.