To restore confidence and boost spending, the Reserve Bank of India (RBI) will sharply cut interest rates next year, but the decision will not be easy, say lenders.
After a year of record rises in domestic wholesale prices and global credit crunch, consumer confidence has taken a beating and banks are shying away from risk, fearing loan defaults.
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RBI’s repeated rate cuts since October haven’t yet helped ease credit demand. While state-owned lenders have reduced key rates, private and foreign banks are still reluctant to do so.
“Today it is not so much about interest rates; it is about demand. A slowdown in demand affects the number of commercially viable projects,” says Saugata Bhattacharya, an economist with private sector Axis Bank Ltd. “Though there is no formal data on consumer spending in India, we see consumers turning wary of spending. Particularly, they are staying away from the credit market.”
Still, Bhattacharya argues that banks are right in being cautious and conservative, as “the economic environment is highly unpredictable and uncertain”.
The global credit crunch as a fallout of the subprime crisis in the US and the resulting collapse of banking and financial institutions in that country and Europe has forced drastic rate cuts worldwide.
The US Federal Reserve cut its key policy rate to a historic low of 0.25% in December from 3% at the beginning of the year. Bank of Japan reduced its policy rate to 0.1% in December, the European Central Bank cut its to 2.5% and Bank of England slashed rates to 2%.
Most analysts say RBI will follow suit and cut interest rates this week or the next, to start with, but they don’t see a drastic reduction.
“The disease has originated in other economies; India is just facing the symptoms of those diseases,” says Rupa Rege Nitsure, chief economist, Bank of Baroda. “Hence, the magnitude and number of steps taken will vary.’’
Abheek Barua, chief economist at HDFC Bank Ltd, agrees. “Clearly, the global central banks’ actions were far more drastic as the problems in the US were far more worse than what it is in India. The same holds for Europe and UK,” says Barua. “India is facing a real economy problem while the US and UK are facing both a financial sector and real economy crisis.”
Nitsure forecasts a 100 basis point cut in RBI’s repo and reverse repo rates and further softening in 2009.
One basis point is one-hundredth of a percentage point. RBI follows two policy rates—reverse repo rate, or the rate at which it absorbs liquidity from the system, and the repo rate, at which it injects liquidity.
“However, a cut in the repo and reverse repo rate without a slash in cash reserve ratio (CRR) will create imbalance,” she says. CRR is the portion of deposits that banks need to keep with RBI.
Barua, too, expects RBI to cut its repo and reverse repo rates by 100 basis points.
“In 2009, fiscal expansion will lead the way while monetary policy will provide adjunctment,” he predicts.
“There is more room for interest rates to come down,” says Neeraj Swaroop, regional chief executive, India and South Asia, Standard Chartered Bank. “While the liquidity situation is better, it is still not sufficient. The real interest rate is too high compared with inflation. I expect a 50-75 basis point cut in both repo and reverse repo and a 50 basis point cut in the cash reserve ratio.”
Earlier in December, RBI slashed its repo rate to 6.5% from 7.75% at the beginning of the year, when it had to raise rates to tame a rapidly rising inflation. It cut the reverse repo rate to 5% from 6%.
To ease the pressure on liquidity in the banking system, RBI also cut CRR to a low of 5.5% in November from 7.50% in the beginning of the year.
Bank lending in November rose by Rs70,208 crore, while investments by banks in government and other approved securities went up by Rs93,216 crore, RBI data shows. According to the weekly statistical supplement of RBI for the fortnight ended 5 December, bank credit increased by 0.4% to Rs9,409 crore.
A month’s data does not make a trend. But analysts warn that if banks continue to pour money into government securities and go slow on lending, it could mean a return to lazy banking, so called because all that bankers do is take advantage of lower interest rates to park their funds in risk-free government securities and make a tidy profit as bond prices rise.
The trend is evident from credit-deposit and investment-deposit percentages as well. The credit-deposit ratio has come down to 74.58% at the end of November from 75.43% in October, according to RBI data.
As on 5 December, the ratio stood at 74.32%.
In contrast, the investment-deposit ratio has gone up from 28.61% at end-October to 30.12% at the end of November. The ratio for the fortnight ended 5 December increased further to 31.12%.
“Interest rates, we feel, are certainly headed lower as the economic growth is likely to slow down in 2009,” says Renu Sud Karnad, joint managing director, Housing Development Finance Corp. Ltd. “Even the developed world is facing a major slowdown, which clearly means lower demand for commodities.”