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RBI Trims Rates, Prods

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The Reserve Bank of India (RBI) cut its key short-term rates by 25 basis points on Tuesday to shore up faltering economic growth, but a key question is whether commercial banks will pass on lower borrowing costs to consumers.

The Reserve Bank has cut its main lending rate by 425 basis points since last October to record lows to spur business activity, but prime lending rates of five major commercial banks have fallen by less than 200 basis points in the same period, according to HSBC.

The following looks at how the RBI's rate cuts could force banks to reduce their lending rates and its impact on growth.

Will The Rate Cuts Force Banks To Reduce Their Lending Rates?
Analysts say the latest RBI cuts, which bring both its key policy rates to record lows of 3.25 per cent and 4.75 per cent respectively, will force commercial banks to reduce lending and deposit rates further and boost loans to credit-starved sectors.

Banks have been parking an record daily average of 1 trillion rupees at the central bank's daily money market window, yielding 3.5 per cent, for the last two weeks.

Loan growth for 2008/09 has dropped far below the central bank's projected levels of 24 per cent and at end-March was at 17.5 per cent from a peak of near 30 per cent in early October.

Until now, the central bank has been bringing down the cost of funds to the banking system by cutting the rate at which it loans funds to banks, but its latest move is seen as a warning that if banks don't cut their rates, it will reduce the minimum rate of interest they earn by investing funds with the central bank.

Will Commercial Banks Cut Lending Rates Soon?
Analysts say the rate cuts will force banks to reduce their lending rates by 50-100 basis points in coming weeks, but it is unlikely to happen immediately as banks have raised funds via high-cost deposits earlier. A government-mandated small savings tax-free rate of 8 per cent also acts as a huge deterrent.

Sonal Varma, an economist at Nomura, said the token cut is to prod commercial banks to reduce their lending rates further.

Another key factor that is preventing banks from reducing their lending rates is a recent surge in bond yields as the government has stepped up its borrowings in recent months.

Benchmark yields briefly shot up by more than 200 basis points this year even as the central bank has cut rates by 175 basis points since the beginning of January.

What Will The RBI's Next Rate Move Be?
Analysts say Tuesday's rate cut may not be its last but it is nearing the end of its rate-cutting cycle. Future moves may also be more measured as it waits for local banks to follow its rate cuts and awaits clues on the next government's fiscal policies.

Rajeev Malik, an economist at Macquarie Securities, said that having cut aggressively the central bank will probably cut another 50 basis points at the most, but the economy will likely benefit from more aggressive lending rate cuts by banks that have been delayed.

Will Growth Revive Soon?
Unlikely, as the slowdown has been steeper than expected and global demand is expected to contract this year.

The RBI cut its growth estimate for fiscal year 2008/09, which ended on March 31, to 6.5-6.7 per cent after grwth averaged growth around 9 per cent in the last three years. It expects the economy to grow by 6 per cent in 2009/10.

In a review in January the RBI expected growth of around 7 per cent and Prime Minister Manmohan Singh said on Sunday the economy will likely grow at 8-9 per cent from September.

With the country in the midst of electing a new government, the growth outlook in the months ahead will largely depend on the composition of the new government and its economic policies. Any political uncertainty after the elections is likely to hurt growth further.

How Will Bond Yields React To RBI Moves?
Piyush Wadhwa, senior vice-president at ICICI Securities Primary Dealership, says benchmark yields will fall more in the coming months with the benchmark 10-year bond yield likely to fall below 6 per cent as the rate cuts indicated the central bank's concern about growth.

The central bank said large borrowings militate against the low interest rate environment that the RBI is trying to maintain to spur investment demand in keeping with the stance of monetary policy.


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