The yield on the benchmark 10-year government bond dropped to 7.56% Friday from 7.61% the previous day, after Reserve Bank of India (RBI) governor D. Subbarao soothed the frayed nerves of bond dealers, saying the central bank will exit from its loose monetary policy at a “calibrated" pace. His statement, made in Hyderabad, could mean RBI is not planning any rate hike before July-end, when it reviews its monetary policy, though wholesale price-based inflation has crossed 10%.

RBI’s liquidity-boosting measures have also made it clear that it doesn’t want any sudden spike in interest rates. After buying Rs8,307 crore of bonds from the secondary market on Friday, RBI plans to buy back more bonds—up to Rs10,000 crore—from banks on Monday. When the central bank buys bonds from banks, it infuses liquidity into the system.

Also Read Tamal Bandyopadhyay’s earlier columns

While this is good news for the financial system, the bad news is that banks are not getting enough money from depositors. Until 4 June, the year-on-year (y-o-y) deposit growth in the banking system was 14.3%, the lowest in at least seven years.

In the year between July 2008 and June 2009 the deposit growth was 19.1%. I have checked the data on the central bank’s website and found that there was a similar slowdown in the banking system’s deposit growth seven years ago. Between July 2002 and June 2003, deposit growth was 11.5%.

To put it in the right perspective, one should remember that the base was much smaller then. The Indian banking system’s outstanding deposits at the beginning of June 2003 were Rs13.29 trillion. Seven years later, in June 2010, they are Rs45.41 trillion.

So, in absolute terms, there is more money flowing in, but this will not be enough to meet credit demand in an economy poised to grow at around 8%.

Till recently, bankers were complaining about the cost of money they were holding as there were not too many takers for loans, but now they will have to actually raise deposit rates to attract money.

India’s largest lender, the State Bank of India (SBI), could not earn enough interest income last year because the bank found it difficult to deploy its deposits profitably.

In the wake of the collapse of US investment bank Lehman Brothers Holdings Inc. in September 2008, there was a flood of money as risk-averse investors shifted their focus from equities to the safety of bank deposits. In the absence of credit offtake, SBI had to park the money with RBI’s reverse repo window and earn 3.75% (the rate was even lower, 3.25% early this year), much lower than what it paid depositors. RBI sucks out excess liquidity from the system at its reverse repo rate of 3.75% and gives liquidity support to the banks, when they need it, at 5.25%, its repo rate.

Now, SBI and its peers may have to raise their deposit rates to attract money. I am told that a few banks have already started raising short-term, high-cost certificate of deposits (CDs) as they fear that they will not be able to meet credit demand unless deposit growth picks up.

A CD is a promissory note issued by a bank and the holders of the instrument cannot withdraw funds on demand. Banks are also planning to raise bulk deposits from corporations at a higher rate—something they hated to do last year.

At this point, most banks are offering around 6% for deposits up to one year and 6.5-6.75% for two years. This is not enough as interest income from deposits is taxed and government-run, tax-free small savings schemes offer at least 7%.

If banks are not able to mop up higher deposits, they will not be able to support higher loan growth. RBI has projected 20% credit growth and 18% deposit growth for the current fiscal year.

At this point, y-o-y credit growth is 19.1% and deposit growth 14.3%. The growth in M3, or the broadest measure of money supply, has also declined to 14.6% after growing at around 20% or more in the past few years. Bank deposits are the main component of M3, besides currency kept with the public.

A key reason behind the drop in the growth of money supply is the absence of RBI’s intervention in the foreign exchange market. The central bank traditionally buys dollars from the market when there is oversupply. RBI buys dollars to prevent the appreciation of the local currency.

A stronger rupee hurts the interest of exporters as every dollar fetches fewer rupees when the local currency strengthens, leading to a decline in exporters’ income in rupee terms. For every dollar RBI buys from the market, an equivalent amount in rupees flows into the system, adding to the supply of money.

The European debt crisis has made the equity markets volatile and foreign institutional investors, the main driver of the market, have not been aggressively buying Indian stocks. So far this year, they have bought $5.49 billion (Rs25,309 crore) worth of Indian stocks net of selling after pumping in $17.64 billion last year.

The biggest challenge before Indian banks now is mobilization of deposits. RBI may have to refrain from raising the cash reserve ratio, or the portion of deposits that commercial banks are required to keep with the central bank, and focus only on raising interest rates as part of its tighter money policy.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at

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