After a series of baby steps, Reserve Bank of India (RBI) governor D. Subbarao finally took a giant stride on Tuesday and raised the policy rate by half a percentage point.
Fighting inflation is now on the top of the central bank’s agenda, and not balancing between growth and inflation, which has been the case so far. Indeed, in the short term, growth will suffer, but RBI doesn’t bother much about this, as persistently high inflation can end up killing growth altogether. By going for a higher dose of rate hike, which not too many central bank trackers expected, Subbarao also made it clear that there is no trade-off between growth and inflation, and the cocktail of high growth and high inflation is not “neo normal” as has been claimed by many to justify runaway inflation.
With the latest rate hike, India’s policy rate is now 7.25%, just above non-food manufacturing inflation, which rose to a two-and-a-half-year high of 7.1% in March. However, this is a provisional figure and it can go up once the numbers are finalized. The last time the Indian central bank raised its policy rate by an identical margin—half a percentage point—was in June and July 2008—from 8% to 8.5%, and then to 9%. The wholesale price inflation then was ruling at double digits, and non-food manufacturing inflation was 7.6% and 8.1%, respectively.
Also Read Tamal Bandyopadhyay’s earlier columns
Has RBI reached the end of its rate tightening cycle? I would not think so. Inflation will continue to remain high—around 9% till September—and since RBI’s policy document has committed to continue with its “anti-inflationary stance”, I would think there is a possibility of another 50-75 basis points (bps) rate hike in phases, but, after a one-shot 50 bps hike, it is unlikely to go for another 50 bps point hike as it had done in July 2008 unless there is a compelling reason. A basis point is one-hundredth of a percentage point.
Inflation has breached RBI’s tolerance level and this is why it has gone for a bigger dose of rate hike. What’s RBI tolerance level for a slowdown in growth? Its growth projection for fiscal 2012 is around 8%, and unless there are clear indications that growth is slipping to around 7.5% or so, it is unlikely to give up its fight against inflation. Its particular concern about inflation seems to be non-food manufacturing inflation. Till such time it is under control, RBI will continue to raise its rate.
Both the equity and bond markets reacted to the rate hike; particularly bank stocks bore the brunt. But for banks’ balance sheets, in the long run a 50 bps hike in savings bank account is more critical than a policy rate hike. This is a boon for the saving community, but banks’ cost of funds will go up substantially and as a result of which their net interest margin, or the spread between deposits and yields on advances, will go down. This will impact their profitability.
The savings bank rate is the last bastion of mandated rates in the Indian banking system. Since March 2003, it has been kept unchanged at 3.5%. The last time the savings bank interest rate was raised was in April 1992. This is the first hike in nearly two decades.
Savers will benefit from this as they have been persistently earning negative returns from savings bank accounts with average inflation in fiscal 2011 ruling at 9.4%. In some sense, the savings bank account rate is the biggest subsidy that the Indian bankers have been enjoying. Till about a year back, banks were paying interest on the lowest amount kept in a savings account between the 10th and the last day of any month. By this calculation, the effective interest rate earned by consumers was 2.7%, and not 3.5%.
Last year, RBI changed the norms and directed banks to calculate interest daily for the funds kept in such an account. Following this, depositors started earning 3.5%. But interest income on bank deposits is subject to income tax. This means if one is paying 30% income tax, her earnings from a savings bank account is 2.45%, Rs 2.45 on a deposit of Rs 100, after tax. Since average inflation was 9.4% in fiscal 2011, the actual return was Rs 93.05. In other words, the value of money kept in a savings bank account was eroded by close to 7% last year. With the hike in rate now and average 8% inflation during the current year, the value erosion will be less, about 5.2%. On a Rs 100 deposit, one would get Rs 94.80.
What is good news for savers is bad news for bankers as their cost of funds will go up. Roughly, savings bank deposits constitute around 22% of the Rs 53.25 trillion deposit portfolio of the Indian banking industry. The industry’s cost will rise by about Rs 6,000 crore and the impact on banks’ margin will be around 10 bps.
Why did RBI raise the rate? After all, just a week back it released a discussion paper on deregulating the savings rate. Does this also mean that it will go slow on freeing the rate? That may not be the case. It had first explored the option of freeing the savings bank rate in 2003 and later in 2007, but it could not do so in the face of stiff opposition from the banking industry. All other deposit rates were deregulated by 1998.
Bankers have been opposing the move as they fear once it is freed, it will trigger a rate war and their cost of funds will go up. The rate hike is a tactical ploy to take the sting out of banks’ opposition. Now banks will be less aggressive in opposing RBI’s move as their cost of deposits will rise even without deregulation. They have nothing much to lose.
Banks will also have to set aside more money for their bad assets. This and the higher cost of savings deposits will impact their profitability. Till now all bankers have been focusing on Casa to bring down their cost of deposits. While they do not pay any interest on ‘Ca’ (current accounts), their cost on ‘Sa’ (savings accounts) is up. They would need to take a close look at the cost of liabilities and find innovative ways of asset-liability management if they want to maintain profitability.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to firstname.lastname@example.org