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The low cost of incremental deposits is the reason why banks  are cutting their loan rates aggressively. Photo: Bloomberg
The low cost of incremental deposits is the reason why banks are cutting their loan rates aggressively. Photo: Bloomberg

For borrowers, how long will the good times last?

The honeymoon of the borrowers could be short lived as banks will start raising the loan rates once they see the flight of deposits

Banks and mortgage firms in India are in a rush to cut loan rates in the aftermath of the deluge of deposits in the past two months.

By a rough estimate, around 86% of the Rs17.3 trillion currency in circulation—Rs14 trillion—consisting of Rs1,000 and Rs500 currency notes, was banned on the midnight of 8 November, prompted by the government’s resolve to fight black money, terror financing, counterfeit notes and push for a cashless economy.Or, that was the assumption at that time. But as the exercise progressed, analysts and different agencies started throwing up higher figures. Those notes are being replaced with new Rs2,000 and Rs500 banknotes. The window for submitting the old notes closed on 30 December.

The banks started announcing rate cuts from 2 January. The final figure of how much money has come back to the system is not yet known. News reports on Wednesday evening suggested it could be as much as Rs15 trillion, although no official figure is available as yet. Flooded with money and a historic low credit offtake, banks are cutting loan rates to prop up demand.

State Bank of India (SBI), the country’s largest lender, has cut its marginal cost of funds-based lending rate or MCLR—the anchor for all loan rates—by 90 basis points, a margin of cut not seen in recent times. One basis point is a hundredth of a percentage point.

Incidentally, for SBI and many other banks, this is the second round of cuts in the past two months. They had cut their MCLR as well as deposit rates in November, albeit by a smaller margin.

Homebuyers have benefited the most, as the mortgage rate in India is now the lowest in the current decade. The last time we had seen such sharp rate cuts in home loans was in 2009-10 after the collapse of iconic US investment bank Lehman Brothers Holdings Inc. that led to a trans-Atlantic financial crisis.

SBI chairman Arundhati Bhattacharya has said the cut in interest rates is promoted by liquidity and aims at jump-starting credit growth. While there is no sign of private investments picking up, banks are now desperately trying to woo retail customers. They are also being goaded by Prime Minister Narendra Modi to keep the poor, the lower middle-class, and the middle-class as the focus of their activities.

Year-on-year, up to 9 December, the banking system’s deposit growth has been 15.9%, against 10.9% last year. In the first eight months of the current financial year, the growth has been 13.6%—almost double that of the comparable period in the previous year.

In contrast, the year-on-year credit growth has just been 5.8% against 10.6% a year ago. Since April, the credit growth has been just about 1.2% against 6.2% in the first eight months of the previous year. Between 11 November and 9 December, banks’ deposit base has risen from Rs1.01 trillion to Rs1.06 trillion but the credit growth has virtually stagnated. In the next fortnight, till 24 December, there has been further drop in credit growth to 5.1% even as the deposit growth slowed to 15.15%.

Clearly banks have no choice but to cut loan rates to prop up their loan portfolio. Two key questions at this juncture are: Will the deep rate cut create the demand for credit? And, how long will this regime of low interest rates last?

Typically, in the second half of the financial year after the harvest of crops, credit demand picks up. This has not been the case this year as the sudden withdrawal of 86% of the currency in circulation—around 10% of India’s GDP—and the not-so-efficient replacement with new notes dented both demand and confidence of consumers.

By just cutting interest rates, credit demand cannot be created overnight. It will take a while but by the time consumer confidence is restored, loan rates may not remain at the current low levels. This is because this liquidity will not remain with the banking system forever. Once the restrictions on withdrawal of money are lifted (it will probably happen over the next few months, gradually), the banks will see the outflow of deposits and the currency in circulation will be back—if not fully, at least to a large extent. As and when that happens, banks will be forced to raise their loan rates. In that case, why are the banks in a hurry to cut their loan rates and that too by such a wide margin? Why aren’t they cutting their deposit rates too?

They don’t need to cut their deposit rates as the bulk of new deposits they have mopped up consists of current account and savings accounts, or CASA. Banks do not pay any interest on current accounts and the cost of the savings account for most banks is 4%. So the cost of incremental deposits that the Indian banking system has mobilized in the past two months could be less than 4%. Even after accounting for 4% of the liabilities which they are required to keep with the Reserve Bank of India (RBI) as cash reserve ratio on which they do not earn any interest rate, the cost of money raised in the past two months could be around 4%. So, why would they need to cut the deposit rates further, particularly when there is no demand for loans?

The low cost of incremental deposits is also the reason why they are cutting their loan rates aggressively. If there is no demand for money—both in the form of loans as well as bonds—the only avenue for earning for the banks is the RBI’s reverse repo window. When a bank wants money, it can borrow from the RBI at the repo rate which is 6.25% now.

Similarly, if a bank is flush with money, RBI can soak that up, offering 5.75%, its current reverse repo rate. If the central bank soaks up the excess liquidity through auctions, it can pay even less. So, anything which offers a bank more than the RBI’s reverse repo rate is a better option at this point than keeping money in vaults and not earning anything.

However, the honeymoon of the borrowers could be short-lived. The banks will start raising loan rates once they see the flight of deposits.

Incidentally, since January 2015 when the RBI kicked off its rate cut cycle, the policy rate has come down by 175 basis points—from 8% to 6.25%. Till the last round of rate cuts banks had not passed on the full benefit of the policy rate cut to the borrowers but now they have done so. What the RBI could not achieve in its entire 82-year history, demonetization could—monetary transmission. It’s another matter that it may not last long.

Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. He is also the author of A Bank for the Buck, Sahara: The Untold Story, and Bandhan: The Making of a Bank.

His Twitter handle is @tamalbandyo.

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