PremiumBanks have been raising interest rates on their loans as well as deposits. A simple explanation is that the Reserve Bank of India (RBI) recently raised the repo rate by 90 basis points (bps) to 4.9%. The repo rate is the interest rate at which RBI lends to banks. One basis point is one-hundredth of a percentage.
The major reason behind interest rates going up is the rise in the one-year incremental credit-deposit ratio. The incremental credit deposit ratio on 9 April 2021 was around 37%. This meant that of every ₹100 of deposits raised by banks in the year before that date, only ₹37 had been given out as a loan
This ratio has been increasing since then and stood at around 111% as of 17 June. This meant that of every ₹100 of deposits raised by banks in the year prior to 17 June, ₹111 had been given out as a loan. Simply put, in the last year, banks have given out more loans than raised deposits.
Of course, they could do this by using deposits they had borrowed before the last year. However, at the same time, they have used other sources to fund these loans.
A major reason for this lies in the recovery in lending to companies. The overall lending to industry in May rose 8.7% from a year earlier, with lending to micro and small industries growing by 33% and to medium-sized businesses growing by 49.3%. In comparison, in May 2021, things were rather flat, with lending to the industry growing by just 0.2%.
At the same time, the growth in retail loans is happening at a faster pace now than a year ago. Retail loans grew by 16.4% in May, outpacing the 12.8% gain in the year-earlier month.
As lending has increased, so has the need to finance the loans through deposits. In the process, interest rates have been rising. Simultaneously, excess money in the financial system has also been coming down. In the aftermath of the pandemic, the RBI printed and pumped money into the financial system to drive down interest rates to help the government, corporates, and individuals borrow at lower interest rates. The idea was to help fuel consumption and drive economic recovery.
The excess money as of 3 July stood at ₹2.8 trillion. At its peak, in early September 2021, this had stood at more than ₹9.2 trillion.
The RBI, in its fight against inflation, has gradually been withdrawing this excess money from the financial system. This has also pushed up interest rates.
The conclusion we can draw from this is a rather tricky one. The RBI wants interest rates to go up. However, while interest rates have been rising, they have risen because bank lending has picked up.
Clearly, the economy as a whole is in much better shape now than it was at the same time last year. So the entire idea behind the RBI wanting to increase interest rates is to slow down lending growth and, in the process, limit demand. Less demand hopefully will lead to lower inflation, but that isn’t happening as yet.
This tells us that rising interest rates don’t always stop corporates and individuals from borrowing and that is more a function of how they feel about their economic future at a given time. Clearly, there is more optimism right now than there was a year ago.
Nonetheless, it is also too early in the cycle of rising interest rates. Will this optimism continue as RBI and other central banks keep raising interest rates to control inflation? That remains to be seen.
