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Strong, Bitter Medicine
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Use that analogy to analyse the credit policy, and one will realise the treatment has only begun. By announcing a half percentage point hike in policy interest rates — mainly the repo rate, at which banks borrow from the RBI for managing liquidity needs almost every day — or 50 basis points (bps), the central bank seems to have signalled that its treatment (policy rate hikes) for persistently high inflation throughout the economy thus far has not worked, so it decided to give the banking system stronger medicine (aggressive rate hikes).
"Giving it such a booster shot at what most thought were near the end of the hiking-cycle seems a little out of place," says Indranil Pan, chief economist at Kotak Mahindra Bank. The RBI has also made borrowing terms tougher: it has said that banks can borrow up to 1 per cent of net deposits at 1 per cent higher than the repo rate of 7.25 per cent (at 8.25 per cent).
Rajiv Kumar, economist and director general of the Federation of Indian Chambers of Commerce and Industry, is worried that maintaining growth would be difficult. "It will actually slow down growth," says Kumar. "Employment targets cannot be met and that could add to social pressures."
In his address to bankers, and in his policy statement, RBI governor Duvvuri Subbarao said as much, that the country would have to forego some growth in the short term to ensure sustainable growth in the longer term. How short? The rest of the year, perhaps. The RBI pegs gross domestic product (GDP) growth at 8 per cent for FY12.
It Was Always About Inflation
But what makes this policy more interesting are some of the structural changes that accompany the aggressive policy-rate hike, to give it more bite in the battle on inflation. First, rather than use a corridor between the repo and reverse repo (the rates at which the RBI ‘borrows' excess securities from banks), monetary policy will now use a single signalling rate, the repo rate. Second, it will increase the costs for banks to borrow through the newly instituted marginal standing facility (MSF), which banks can use to borrow additional liquidity. The interest rate on MSF borrowing will now be 8.25 per cent, instead of 7.25 per cent.
Third, the central bank has raised the cheapest form of bank ‘borrowing' — savings bank deposits — from 3.5 per cent to 4 per cent, after leaving it untouched for almost nine years. Banks make a big spread on this segment of deposits, and their net-interest margins (NIMs, or the difference between interest paid on deposits and interest earned on loans) could come under some pressure. In addition, savings bank interest rates could go up each time the repo rate is increased.
Should savings bank interest rates have been raised at this juncture? They constitute roughly 22 per cent of the total deposit base of the banking system. The current hike apart, not everyone is happy with the thought of the eventual deregulation either. "Casa (current and savings account) deposits, which are core deposits, will become volatile," says Mohan Shenoi, treasurer at Kotak Mahindra Bank. "Currently, in liquidity statements, they are included in the 1-3 year range. Now, we will have to put them in the less- than-one-year bucket. And that could change the cost of deposits significantly."
Others think deregulating savings banks rates is necessary. "Savers need to be compensated especially as inflation levels are around 8.5 per cent," says South African FirstRand Bank's treasurer Harihar Krishnamoorthy. "Policy transmissions get muted when a large part of deposits are at low, fixed levels and render lending rates less dynamic."
Stimulus Versus Response
What will banks do? "Most banks will try to maintain margins, but a large part would have to be passed on through increase in lending rates, say 50 to 100 bps," said Chanda Kochhar, managing director and chief executive officer, ICICI Bank, at the bankers' conference after the annual policy announcement. "By definition, EMIs should go up," said Aditya Puri, managing director and CEO of HDFC Bank, at the conference. "The RBI has made money dearer. Now, the banks' asset liability committees (ALCO) will make the final decision (on interest rate hikes to borrowers), but there could be a 50-bps hike in lending rates."
Puri was right. IDBI Bank announced a rate hike in its base lending rate of 50 bps within hours of the policy announcement on 3 May. Punjab National Bank and Yes Bank followed the next day announcing similar increases. LIC Housing Finance and Bank of Maharashtra were next. In the coming days, the entire banking sector will follow suit.
Banks have another problem on the big deposits side, too. The RBI has sought to reduce the interdependence of banks and mutual funds in managing liquidity. Over the past years, banks' investments in liquid funds of debt-oriented mutual funds (DoMF) have grown manifold. DoMFs are huge lenders in overnight money markets, especially in the collateralised borrowing and lending obligation market, where banks are the biggest customers.
DoMFs invest heavily in certificates of deposit (CD) of banks. "Such circular flow of funds between banks and DoMFs could lead to systemic risk in times of stress or liquidity crunch," the RBI said. Accordingly, it capped banks' investment in liquid schemes of DoMFs at 10 per cent of their net worth as on 31 March of the previous year and has given them six months time to comply.
Bank treasurers say this could result in a reduction in banks' earnings, besides affecting mutual funds. "It will also impact mutual funds' assets under management, although the impact will be differential," says Bekxy Kuriakose, head of fixed income at L&T Mutual Fund.
Prudence And The Bitter Pill
The forced reduction in reliance on mutual funds is part of the prudential regulatory change announced in this year's monetary policy. There have been changes to provisioning norms, which could have considerable impact on banks' after-tax profits in the coming year or two.
Why? Because with long-term increases in interest rates — that is the expected impact of the recently announced measures — non-performing assets could go up dramatically for many banks. The increase in provisioning is preemptive, to make sure balance sheets are not stressed. Provisioning for substandard assets (those that are overdue for 91 days) is now 15 per cent (up from 10 per cent) and that for doubtful assets (overdue for a year) is 25 per cent (from 20 per cent).
What will this do to credit growth that has been almost 23 per cent compared to the targeted 17 per cent? "The increase in provisioning, by itself, should not have any impact on credit growth," says FirstRand's Krishnamoorthy. "It may impact profits on a one-time basis for some banks, though."
It is not all tightening, though. In another move that could help the government securities (G-Secs) market, the RBI increased the time span for short selling of G-Secs from five days to 30 days. "We have been receiving requests for this," says Shyamala Gopinath, RBI deputy governor. "Till now, it was not possible to take long positions in interest rate futures (IRFs). This will help investors take long positions in IRFs and encourage a term repo market."
This policy may have restored the RBI's credibility as inflation fighter in some corners, but it has also worried others; some wonder whether the end of the tightening cycle is far from over. "The RBI has also said that there are clear upside risks to inflation because of oil and commodity prices," says a bank economist.
(This story was published in Businessworld Issue Dated 16-05-2011)