The Reserve Bank on August 7 slashed the repo rate --- the rate at which it lends to the banks --- by an unconventional 35 basis points (or 0.35%) to 5.40%. At 5.40%, the repo rate is the lowest in more than nine years. The 35 basis repo rate cut marks the fourth consecutive cut. Since August 2018, the cumulative interest rate action has led to a lowering of repo rate by 110 basis points, but the current transmission is only 29 bps. This means if the RBI has cut repo rate by 1.1%, the banks have cut their loan interest rate by merely 0.29%. So, why are banks not cutting loan rates by 110 basis points? Many would argue that the Indian banking industry is already saddled with Rs 10 lakh crore bad loans, and is cautious about lending.
But, if banks do not lend at lower rates, the economy will not benefit from the RBI and the government's pro-growth stance. The government and the central bank seem to think that demand for consumer durables, homes and cars is largely driven by interest rates. Is it so? The truth is if the banks do not cut rates, the RBI cannot force them to do so. As a result, there won't be boost to consumption. The RBI can only lower repo rates by only so much or free up money to lend by banks. Let us find out more on this.
Sticky deposit rates
One of the reasons why banks may not be able to cut loan rates is because of deposit rates. Banks cannot lend at 6% if they offer 7% interest to deposits. Are we ready for 5% bank Fixed Deposits (FDs)? There is a lot of pressure on the banks to maintain fixed deposit rates (FDs). This is one of the key reasons why the RBI repo rate cut is not being transferred to borrowers. "With a decline in household savings to GDP and competition from the government’s small savings rate, the banks have limited scope to lower deposit rates. Consequently, deposit growth remains sluggish at 10.6% Y-o-Y despite high real interest rates. Therefore, term deposit (TD) rates continue to remain sticky hindering policy transmission," says Reliance Securities research analyst Mona Khetan.
The government needs to look at the small savings rates and reduce them in line with the market rates. "If that does not happen, then the ability of banks to reduce deposit rates and hence ease the lending rates will be limited. For example, currently a five-year National Savings Certificate fetches an interest of 8% while Sukhanya Samridhhi scheme offers 8.5%, which is way higher than the 6.80% rate which SBI is offering for deposits above 1-year tenure," says T V Narendran, vice-president, CII.
State Bank of India (SBI), the country's largest lender, has revised its FD rates across all tenors. The bank has sharply cut the interest rate on FDs ranging from 45 days to 10 years. Indranil Sen Gupta, India Economist, DSP Merrill Lynch (India) told investors that he expects banks to follow the SBI in slashing deposit rates. "A 25 bps deposit rate cut funds 30-35 bps of lending rate cuts. The RBI has pro-actively infused durable liquidity since December. It typically takes about 6 months for Re 1 of RBI liquidity to 'multiply' into Rs 5 of deposits/credit," he says,
The RBI and the government seem to believe that borrowers avail loans only if interest rates are low. But if talks of an economic slowdown are true, borrowers may not be as buoyant about loans as they were earlier. Also, the indebtedness of households has risen while there is no real growth in income. Index of Industrial Production (IIP), moderated in May 2019, pulled down by manufacturing and mining. The growth in eight core industries decelerated sharply in June. A slowdown is not a good backdrop for banks and borrowers to deal with loans. Probably, that is why banks are cautious about lending.
Economic data released for May-June indicates a slowdown. "Tractor and motorcycle sales, indicators of rural demand, continued to contract. Urban demand and passenger vehicle sales contracted for the eighth consecutive month in June. However, domestic air passenger traffic growth turned positive in June after three consecutive months of contraction. Investment indicators such as steel consumption, cement production, construction activity and import of capital goods contracted," according to monetary policy analysis and outlook by Franklin Templeton Investments.
Private sector investment is not happening at the rate it should for an economy that targets to become $5 trillion in size over the next few years. "The impact of monetary policy easing since February 2019 is expected to support economic activity, going forward. The RBI has done its job; now it is for the government to change gears to hasten the growth engine which has been slowing," argues Dhiraj Relli, MD & CEO, HDFC Securities.
According to Franklin Templeton Investments, lower interest rates alone won't be able to solve the current economic problems. 'Therefore, the central bank’s steps need to be supplemented with policy changes and reforms aimed at spurring activity in various sectors," it said.
One of the ways to revive the economy is to nurse back the NBFC sector to health. Due to IL&FS and DHFL crises, the liquidity situation has been bad for NBFCs. These companies act like shadow banks and form an important part of the economic system. "The steps taken to revive lending to the NBFC sector through higher bank exposure limits to a single entity and expanding the priority sector credit definition will help alleviate the funding challenges in the sector and facilitate higher credit flow to the retail segment," says Suman Chowdhury, president-ratings at Acuité Ratings and Research. (The author is a journalist with 14 years of experience)