Mumbai: In what could possibly be the last rate cuts till the new government takes over at the Centre in June, the Reserve Bank of India (RBI) cut its two key policy rates by 50 basis points each on Wednesday evening, after the equity and bond markets had closed for trading. One basis point is one-hundredth of a percentage point.
RBI cut its repo rate, or the rate it charges banks to lend them funds, to 5% and the reverse repo rate, or the rate it offers to banks for parking their excess liquidity with the regulator, to 3.5%.
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Pressure from the government and various industry lobbies has been mounting on the Indian central bank to cut rates and bolster the sagging domestic economy. This pressure intensified last week after the government said the Indian economy, in the third quarter of the current fiscal year, grew at its slowest rate since 2003. Growth in the quarter came in at 5.3%, far lower than the 7.6% clocked in the second quarter. Lower interest rates are expected to spur demand for loans, and encourage consumers to spend and firms to invest.
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In the currency market, the rate cut will have a negative impact on the value of the rupee as it will discourage overseas investors from buying Indian assets, as returns will drop. The rupee, which pierced the 52 level to a dollar on Tuesday and dropped to its lifetime low, gained on Wednesday, but it may weaken once again following the rate cut.
Companies and individual borrowers may not have much to cheer as banks have limited scope to lower their lending rates, unless they are able to bring down deposit rates. With the small savings rates such as the Public Provident Fund pegged at 8%, banks are finding it difficult to bring down their deposit rates, as rates lower than 8% will drive depositors away from banks. Senior bankers discussed this issue with RBI governor D. Subbarao last week.
According to Saumitra Chaudhuri, member of the Prime Minister’s economic advisory council, the RBI move will not have any immediate impact on rates. “The risk premium on corporates is still very high. Confidence is the issue. Banks would not be able to cut deposit rates beyond a particular point. They have to look at their profitability also,” he said.
Deposit rates seem to be the key to lending rate cuts by banks. “There is a need and lot of scope to bring down the deposit rates,” said Bank of India chairman and managing director T.S. Narayanasami.
“Deposit rates should be aligned to the inflation rate. When the inflation rate is falling sharply and liquidity is ample in the system, this is the time to revisit the deposit rates,” said Narayanasami, who is also chairman of the Indian Banks’ Association, the apex bankers’ lobby in the country.
“This cut is a signal for us, but whether we will cut our interest rate or not depends upon a lot of other factors. We have to see how the market reacts before taking a rate cut decision,” said K.R. Kamath of Allahabad Bank.
One thing that is for sure is that the RBI action will discourage banks to park their excess liquidity at the central bank’s reverse repo window, as they will now earn only 3.5%. Banks have on average parked around Rs64,000 crore in each of the past seven days at the RBI reverse repo window. The year-on-year growth in bank credit has dropped to 19.5% in the third week of February, from around 30% in past few years.
Instead of earning 3.5% by keeping their excess cash with RBI, banks may be encouraged to lend now to earn a little more. State Bank of India, the country’s largest lender, has already cut its home loan rate to 8% and auto loans to 10% for the first year. The rates are low, but more than what RBI offers banks for their excess funds.
Keki Mistry, vice-chairman and managing director of Housing Development Finance Corp. Ltd, said, “To facilitate a demand push in the economy, apart from cutting rates, banks would have to be willing to lend to corporates and small and medium enterprises. Confidence has to come back to the system, for which industry bodies have to work with the banks.”
According to Rupa Rege Nitsure, chief economist of Bank of Baroda, given the extent of the slowdown and the credit crunch, there is a need for aggressive cut in deposit and lending rates. “This is a timely signal for banks to cut rates,’’ she said.
With the latest round of rate cuts, RBI has slashed its repo rate by 400 basis points and the reverse repo rate by 250 basis points since October. It has also cut banks’ cash reserve ratio, or the portion of deposits that banks need to keep with RBI, by 400 basis points. Besides, it has cut the requirement of government bond buying by banks from 25% of their deposits to 24%. Collectively, RBI measures since October have released Rs4.28 trillion into the banking system.
RBI may not have much headroom to cut its policy rate further as the mandated savings bank rate in India is currently pegged at 3.5% and the policy rate probably cannot be lower than this. It cannot cut the savings rate now as it could snowball into a major political issue ahead of the general election.
So, at best the banking regulator can cut its repo rate and close the gap between the repo and reverse repo rate by keeping 3.5% as the floor.
Graphic by Paras Jain / Mint