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MUMBAI : With most of their loans linked to an external benchmark, small businesses will feel the bite of rising borrowing costs almost immediately as the Reserve Bank of India’s (RBI’s) surprise 40-basis points rate hike ripples through the banking system, experts said.

A large chunk of loans taken by small borrowers is linked to an external benchmark and, more often than not, to the repo rate. A 40-basis points (bps) hike would increase their borrowing cost by an equivalent amount. For larger firms, lending rates are primarily linked to the marginal cost of funds based lending rate (MCLR), an internal benchmark where transmission is slower than external benchmarks like the repo and treasury bills.

Divergent paths
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Divergent paths

As of December, 70.9% of all loans to large industries were linked to MCLR and 20.4% to external benchmarks. For small businesses, loans linked to MCLR were at 24.2% of their aggregate loans, while 69.2% of loans were on external benchmarks, showed data from the Reserve Bank of India (RBI). The monetary policy committee (MPC), through its 40 basis point (bps) repo rate hike on 4 May, reversed the cut effected during the pandemic in May 2020.

“Companies that are doing very well and seeing good demand will continue investing, but sectors seeing subdued demand will have no reason to invest when the capital cost is high," said Madan Sabnavis, chief economist, Bank of Baroda.

Demand for cement, a key indicator of economic activity, when plotted against changes in RBI repo rate, showed divergent correlation over the years, according to data analyzed by Nirmal Bang Institutional Equities.

For instance, while the repo rate was lowered by 40 bps in 2020-21, demand for cement declined by 1%. In contrast, when the rate was cut by 25 bps in FY18, cement demand jumped 7.1%.

That said, the idea of a rate hike is to rein in demand and, in the process, control inflationary pressures in the economy.

While fiscal policy controls the supply side, the monetary policy helps correct excess demand.

Experts said that since the Indian economy is already experiencing high inflation, consumption will remain subdued, and people will spend more on necessities.

Therefore, the overall capacity utilization, which has been somewhat improving, will now slow, hampering future investments.

“Interest rate is just one factor among many in boardroom discussions on investment decisions," said Samuel Joseph, deputy managing director, IDBI Bank.

Joseph said that although the investment cycle and interest rates are correlated, it is more linked to the real interest rate than the nominal rate.

“The most important factor is the economic outlook for the sector in the medium term," he added.

Analysts pointed out that the relationship between loan growth and policy rates has not been quite strong, with a lot dependent on the nature of growth and the phase of economic growth.

India reported strong growth in the 2003-08 period despite a rising interest rate cycle and a weak loan growth post-2014 despite a weakening interest rate cycle, analysts at Kotak Institutional Equities wrote in a note on 4 May.

Other experts said that the attempt to rein in inflation by the central bank would improve growth prospects over the long term. While the hike is not expected to immediately impact demand for home loans, the real estate sector is wary and is banking on a continued momentum for mortgages. Given that the May hike is just the beginning of the turn in the rate cycle and the end of benign interest rates, housing demand—a key driver for retail loan growth—will be closely watched.

“The sector has vastly benefited from the low-interest rates in the last two years. This policy rate hike will translate into higher equated monthly instalments (EMIs) for home loans," said Gulam Zia, senior executive director, Knight Frank India, a property consulting firm.

Zia, however, hopes that the improved homebuyer attitude, preference for owning a house and strong wage growth will continue to support the housing market.

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