When the country’s largest lender hikes its deposit and loan rates, it means that interest rates are headed only one way—up. But early signs were visible at least eight months before State Bank of India (SBI) raised rates. One key metric that showed where rates were headed was the credit-deposit ratio.

The credit-deposit ratio of the banking sector is an excellent indicator of the direction of interest rates. What this ratio shows is how much of their deposits banks can deploy to earn money. If banks are able to lend all their deposits, it means they can comfortably increase loan rates as demand is strong. If loan offtake weakens (which was the case so far), banks will have to lower their price to attract customers.

The credit-deposit ratio has been subtly inching up every month since July 2017 and was at 74.39% as of 2 February. That means as of that date, banks were able to deploy around Rs74 out of every Rs100 deposit as loans while the rest was parked in government bonds and other investments. Exactly a year ago, they could lend only Rs70 out of every Rs100 deposited.

But we should also see the incremental credit-deposit ratio. The incremental ratio shows how much of fresh deposits were being lent out by banks. This ratio has rocketed to 120%, which means banks had to borrow as the deposit flow was not enough to meet incremental credit demand.

Recall that the deposit deluge courtesy demonetisation at the fag end of 2016 had brought this ratio to as low as 20% since most banks had to park the demonetisation deposits in government securities amid tepid loan demand. What demonetisation did was bring down deposit rates as banks otherwise would lose money (since loan offtake was low). This cycle has now reversed and banks now believe they will have to keep attracting deposits or face liquidity issues. Hence interest rates on deposits have begun climbing and lending rates will have to follow.

Another major sign of rising interest rates is the government bond yield. Sovereign bond yields have been rising since July and are up 125 basis points over the last six months. When the sovereign’s cost of borrowing goes up, it has a bearing on the price of private credit. This is more so when the government is poised to borrow more due to fiscal slippages. Demand for credit from all parts of the economy has increased and simple economics states that price should follow. The gross domestic product numbers for the third quarter indicate that a cyclical recovery has begun.

The tipping point of the interest rate cycle is now behind us. We are already climbing the hill. How steep the slope gets will depend on how the banking sector’s liquidity situation enfolds in the coming months and the Reserve Bank of India’s response.

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