Home >Market >Mark-to-market >RBI rate cuts could reduce lending rates by 75 bps

While the Reserve Bank of India (RBI) has reduced its policy rate by 25 basis points (bps), its measures to increase liquidity in the system could lead to a substantial lending rate cut, perhaps by as much as 75 bps. One basis point is 0.01%.

Here’s how it might work. The RBI’s Monetary Policy Report says that prior to the current rate cut, while the repo rate had been reduced by 125 bps since December 2014, the weighted average lending rate of outstanding rupee loans had fallen by a mere 53 bps. This was despite the weighted average domestic term deposit rate coming down by 80 bps because the banks wanted to protect their margins as their asset quality deteriorated and provisioning for bad loans increased. In other words, if the entire RBI rate was to be passed on to borrowers, then the weighted average lending rate could fall as much as another 72 bps.

Assuming that banks do not pass on 20 bps worth of rate cuts to borrowers to protect their margins, it would still mean lending rates could be slashed by another 50 bps. And that’s not taking into account the 25 bps rate cut RBI delivered on Tuesday. Taken together, this means lending rates could come down as much as another 75 bps in the medium term, as liquidity progressively increases and deposit rates fall. Of course, it’s not going to be as mechanical as that and there are many other factors that will impinge on interest rates, but the fact remains that even without further policy rate cuts, if policy transmission improves, there could be a substantial fall in bank lending rates.

What in the monetary policy statement is so favourable for market liquidity? Firstly, RBI now recognizes that lack of liquidity is hampering transmission of policy rates. Secondly, RBI will now “lower the average ex-ante liquidity deficit in the system from 1% of NDTL to a position closer to neutrality". Simply put, that means while the central bank used to ensure liquidity in the system so that banks didn’t have to borrow more than 1% of their demand and time liabilities from RBI, now they will progressively try to ensure that, on average, borrowing from RBI is not needed. That will reduce banks’ cost of funds and enable them to lower lending rates. Third, RBI has talked of ensuring not just adequate short-term liquidity, but also “durable liquidity in the economy to facilitate growth". Towards this end, it has decided to “smooth the supply of durable liquidity over the year using asset purchases and sales as needed". There are other measures, but the key takeaway is this: RBI will ensure adequate liquidity and not just for the short-term, either through intervening in the forex markets or through open market operations (OMOs).

What explains the market reaction then? Rate-sensitive stocks had run up sharply after the Union budget stuck to the fiscal consolidation road map, the central government reduced interest rates on small savings deposits and banks shifted to lending rates based on marginal cost of funds. Bond yields too had plummeted. A bit of profit-taking is thus entirely in order. Note also that global markets too were under pressure on Tuesday. The markets should rally once RBI walks the talk and they realize the implications for monetary transmission and the scope for lending rate cuts.

What about further policy rate cuts? The central bank is very concerned about the impact of the 7th Pay Commission recommendations. The Monetary Policy Report says, “The direct impact of the 7th CPC recommendations on headline inflation is expected to be around 150 basis points. The indirect effects are estimated to be around 40 basis points". The baseline projection of inflation for the fourth quarter of 2016-17 is 5.1%. Therefore, further policy rate cuts aren’t likely to happen easily. But then, if lending rates do indeed fall sharply as monetary transmission improves, there’s little need for more policy rate cuts.

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