Bank stocks seem to be loving every word of new Reserve Bank of India (RBI) governor Raghuram Rajan. In the past few days, some bank stocks have risen by more than 20%. Why has there been so much of euphoria over Rajan’s maiden statement? Immediately after taking over on Wednesday, he spoke, among other things, about issuing new bank licences by January; exploring the possibility of converting large cooperative banks into commercial banks and putting in place a system of “on tap” licensing; and freeing branch licensing. All well-run banks will be able to expand their branch networks in rural and urban India without the need for RBI’s nod.
While these steps signify reforms in the banking sector, commercial banks will get an immediate benefit from the RBI swap window for deposits from non-resident Indians (NRIs) and overseas borrowing. While the swap windows will ensure foreign fund flow into India and, to that extent, help the country narrow the gap in its current account, banks will also benefit as this will add to their profitability with the cost of liability going down. Analysts are estimating a fund flow of as much as $10 billion.
RBI has opened two swap windows—one for fresh NRI funds of three-year maturity or more, and banks’ overseas borrowing. The cost of swap for the NRI fund is capped at 3.5%. The cost of swapping foreign borrowing for banks is not capped at any rate but it is one percentage point lower than the prevailing swap rate, which is currently at around 7%. Till now, banks were allowed to borrow up to 50% of their core capital. The limit has been doubled.
Banks will swap their dollar funds—flowing through both the NRI deposits and overseas borrowings—with RBI with rupees, and when they are required to repay their depositors and lenders, they will get their dollars back from RBI. The cost of converting the dollar fund into rupee at market rate would have been much higher. In other words, RBI is subsidizing their cost of funds. A similar arrangement was put in place when State Bank of India tapped NRIs for the India Millennium Deposits in 2001. The bank bore a burden of up to 1% of rupee’s depreciation while the government took care of the rest. In this case, RBI is taking care of the rupee depreciation. Of course, if the rupee appreciates from the current level, three years down the line when the NRI deposits are due for redemption, the swap cost will go down.
On top of the subsidy that the banks will enjoy on the cost of such deposits, the NRI deposits will also not be subjected to the usual preemptions such as SLR (statutory liquidity ratio, or the mandatory buying of government bonds) and CRR (cash reserve ratio, or the portion of deposits banks have to keep with RBI and on which they will be paid no interest) as well as the so-called priority sector loan norms, under which banks are required to lend 40% of their deposits to farmers and other small borrowers. Both the windows will remain open till 30 November.
RBI will probably drain the rupee that will be generated through the swaps by selling bonds.
One can expect that Rajan will not reverse the short-term tightening of interest rates till these concessional windows remain open as banks cannot have the best of both worlds. He will unveil the mid-quarter review of monetary policy on 20 September. If the 4 September statement is anything to go by, Rajan will not be in a hurry to bring down the short-term borrowing rates, which RBI in August jacked up to 10.25%. His six-and-a-half-page statement is silent on interest rates while his resolve to contain inflation is pretty evident. He wants low and stable expectations of inflation, whether it stems from domestic sources or is triggered by the depreciating rupee.
The impact of the depreciating local currency was evident on India’s wholesale price inflation that rose to 5.79% in July, the fastest pace in five months. The two contributing factors to the rise in inflation have been higher food prices and costlier imports. The so-called core inflation, or the non-food, non-oil manufacturing inflation, too, rose to 2.35% against an easing of 2.02% in June. Both are higher than what many analysts had estimated. With retail inflation continuing to be high (9.64% in July), RBI will have little room to ease its monetary policy even if the rupee stabilizes at the current level. On Friday, the Indian currency closed at 65.2450 a dollar, gaining 1.33%. During the year, the rupee has lost 15.71%, the most by any currency in Asia.
The process of paring the short-term rates, which can at the earliest start in December, will be gradual. The growth impetus will come from Rajan’s push for reforms in the financial sector and not low interest rates.
Another critical takeaway from Rajan’s speech is the focus on retail inflation. To retail investors, RBI will issue inflation-indexed savings certificates linked to the consumer price index by the end of November. While this is being done keeping in mind the saving community, one can expect that RBI will have a greater focus on consumer inflation even when forming the monetary policy. Until now, it has taken into account both wholesale and core inflation in monetary policy formulation and not consumer inflation, which has been either in double digits or close to double digits since March 2012.
In sum, managing inflation expectations will remain RBI’s priority and the high interest rate regime at the shorter end may continue for the time being. Those who are expecting Rajan to reverse the August policy measures may have to wait for months before that happens.
Tamal Bandyopadhyay keeps a close eye on everything banking from his perch as Mint’s deputy managing editor in Mumbai. He is also the author of A Bank for the Buck, a book on HDFC Bank. Email your comments to firstname.lastname@example.org