Expect lower EMIs as banks start cutting base rates

As the Reserve Bank of India (RBI) cut the repo rate by 25 basis points (bps) to 7.25%, in its second bi-monthly review of the monetary policy for the financial year on 2 June, some banks followed by reducing their base rates. State Bank of India (SBI) reduced its base rate to 9.7% from 9.85%. Allahabad Bank has reduced it from 10.25% to 9.95%. Dena Bank also cut by 25 bps to 10%. These changes will be effective from 8 June. Punjab and Sind Bank, too, cut its base rate by 25 bps from 10.25% to 10%, effective 3 June. One basis point is one-hundredth of a percentage point.

While the cut was expected, the stock market, which opened flat with a negative bias, fell over 1% after the announcement because of the tone of the statement and upward revision in inflation forecast. “Assuming reasonable food management, inflation is expected to be pulled down by base effects till August but to start rising thereafter to about 6% by January 2016—slightly higher than the projections in April,” said the central bank in its statement. Inflation at 6% in January 2016 means that there will be no scope for cutting rates further during the year.

“Although the RBI has left the door open to further easing in the event of further disinflation, we expect it to stay on a prolonged pause (until end-2016), as we believe that growth is in the initial stages of a business cycle recovery, inflation appears to be stabilising around 5.0-5.5% and inflation expectations are still elevated,” said Nomura in post-policy note.

But what will the rate cut and the expected long policy pause mean for your money? Read on to find out.

Effect on stock market

There are reasons for the stock market to be disappointed. In the past, the central bank had said that it intends to maintain real interest rate between 1.5% and 2%. Therefore, if inflation moves as projected, the real interest rate will actually be 1.25% in January, which will be lesser than the lower limit of the target band of real interest rates. This means there will be practically no scope for the central bank to cut rates during the rest of the year.

“The disappointment in the market is because some people were expecting a reduction of 50 bps. Also, a 25-bps cut was already priced in,” said Dhananjay Sinha, head of research, economist and strategist, Emkay Global Financial Services Ltd, adding that RBI will pause and that there will be no rate cut in the August policy review.

The stock market, as reflected by the S&P BSE Sensex ended the day with a loss of 2.37%. Interestingly, while investors are disappointed that the central bank may not cut rates further, the cumulative 75 bps repo rate reduction so far this year has not helped markets much. Benchmark indices are roughly at the same level as they were when the rates were first reduced in January 2015. This is primarily because of weak corporate earnings. “Markets will be driven by the possibility of revival in corporate earnings, which should start in the second quarter of the current financial year,” said V.K. Vijayakumar, investment strategist, Geojit BNP Paribas Financial Services Ltd.

Effect on loans

The transmission of policy rates into lending rates has been weak in the past. The policy statement this time explicitly noted: “Banks should pass through the sequence of rate cuts into lending rates.” And some lenders have done so.

“Earlier, the RBI had left it to the banking industry to transmit the change in rates in the expectation that it would be passed on to consumers. But now, the (RBI) governor is using the persuasion method. Hence, the transmission is likely to happen,” said Ashvin Parekh, managing partner, Ashvin Parekh Advisory Services Ltd. “You can expect a reduction of up to 25 bps in upper-end products such as home loans. But products such as personal loans or vehicles loans, which are of shorter duration, may see a reduction of 15-20 bps,” added Parekh.

“If you are looking to borrow, opt for a floating rate loan and avoid fixed rate home loans. You don’t want to be locked in at a high interest rate,” said Dilshad Billimoria, director, Dilzer Consultants Pvt. Ltd. When choosing a loan, apart from the interest rate, also look at other costs.

Effect on deposits

The RBI governor said that deposit rates have fallen by 100 bps. Deposits are now giving returns that are lower than what small saving schemes give. The decision to increase or decrease fixed deposit (FD) interest rates depends on various factors such as liquidity and demand and supply conditions. “FD rates have already fallen. We may see a further reduction of 25 bps depending on the bank’s cost of funds. As of now, pre-tax return of debt funds is similar to bank FDs’. Those looking to lock money for the long term in a fixed instrument should go for debt funds instead of bank FDs,” said Anil Rego, a Bengaluru-based financial planner.

Effect on debt investment

Between February and now, long-term debt yields have crept up marginally despite three rate cuts of 25 bps each.

“For investors, this means that the opportunity in the yield curve is only consolidating. In other words, an opportunity for rally remains. But this would require an easing of yields driven by macro numbers such as inflation and a normal monsoon,” said Vidya Bala, head-mutual funds research, Fundsindia.com.

If you are investing in debt funds, long-term ones are a better option than the short-term funds.

“Investors should continue to hold income accrual or dynamic bond funds. But don’t expect any short-term returns from these for now. Short-term rates may continue to ease unless there is a liquidity issue or inflation firms up. To this extent, the opportunity in medium- to long-term debt funds remains better than in short-term funds,” said Bala.

Mint Money take

Although the RBI reduced rates as was widely expected, it is unlikely that further reductions will happen during the year, which is disappointing for the market.

Apart from the sentimental impact of news flow in the short run, the stock market will be driven by the possibility of revival in earnings, or lack of it, in the medium term.

In the debt space, experts say that there is still merit in medium- to long-term debt funds. Investors in FDs may see further reduction in rates, which have already come down significantly. If you are looking for relief in equated monthly instalments, the RBI has done its bit by frontloading the rate cut; now it’s up to the banks to follow.