Banking on banks to lower lending rates

PSBs are struck between the pincers of deteriorating asset quality on one side and potential of lowering net interest margins on the other side. They need to balance well with dexterity to operate in the current competitive environment

Considering evolving macroeconomic perspectives, as expected, RBI kept the policy rate intact in its 3rd Bi-Monthly Monetary Policy statement. Early sign of pick up in the manufacturing sector, near normal monsoon, good prospects of kharif crop, revival of auto sales particularly commercial vehicles, strengthening transportation activity in service sector, mild uptick in manufacturing activity in the month of July 2015 are some of the emerging positive signals in the economy.

On the hand, even though the overall business confidence seems positive, there are imminent signs of slow revival of the economy. The investment as measured by new projects is still weak, flat capacity utilisation and new orders, shrinking exports, drop in corporate sales, low capacity utilisation etc., are some of the areas of concern.

The dire financial state of electricity distribution companies (DISCOMs) is adding to the woes. The consumer price inflation during June 2015 inched higher to 5.4 per cent when compared to 5.01 per cent in May 2015. Retail food inflation reached 5.48 per cent due to rise in food grain prices from a level of 4.80 per cent recorded during the prior month.

Monetary Policy Transmission

One of the key observations of RBI is about the slow transmission of monetary policy direction. Since January 2015 while RBI reduced the repo rate by 75 basis points (one basis point is one-hundredth of one percentage point) till June 2015, banks have barely cut their base rates in varying measures up to a maximum of 30 basis points.

But the deposit rates have been reduced between 75 to 100 basis points. Keeping in view the slowdown in the credit growth to 9.4 per cent on 10th June 2015 compared to 13.37 per cent recorded on 13th June 2014 banks can be benefited if the rate cut is passed on to the borrowers to remain competitive in the market. Moreover looking to the positive signs in the economy, the demand for bank credit is set to rise from Q3 onwards.

Of course, one of the limitations in quick transmission is the disequilibrium between pruning deposit and lending rates in terms of its impact on the profitability of the banks. In case of deposits, the new reduced rate will apply only on fresh deposits till the old term deposits issued earlier come up for maturity which can take longer time according to the residual tenor of such deposits.

But the interest income will be immediately reduced on all advances. Hence banks have to cut deposit rates and wait for their impact to cut lending rates.Liquidity Conditions Due to the continuing slowdown in demand for credit and tepid off take of credit in banks, the liquidity conditions in the money market are comfortable with enough liquidity windows of RBI.

As a result, the call rates continue to stay below the repo rates. RBI therefore continues with its accommodative stance of the monetary policy guidance and awaits fuller transmission of its front loaded rate reductions made so far before a fresh view is taken. Moreover, the developments in food prices, handling of supply side dynamics of essentials and progress of monsoon will be critical to manage the inflation within the band.

Driven by the lowering international crude oil prices, improving external sector dynamics, the current account deficit (CAD) is contained at comfortable level. The evolving domestic business climate suggests that inflation can still be contained within the target of 6 per cent for January 2016 with monsoon forecasted to be better during the rest of the season.

Similarly as far as output is concerned, eight core infrastructure sectors grew by 4.4 per cent in May 2015, the highest growth in six months. When seen this trend in relation to the decline in March and April of 2015, the performance is expected to be better in Q3 onwards. Hence keeping the increased commercial activity in the busy season, RBI expects to contain the GDP projections at the estimated level of 7.6 per cent during FY16.

Challenging tasks for banks

While providing an overall balancing view of the emerging economy based on some of the facts and future perceptions, RBI has left the policy rates intact waiting for banks to pass on the lower interest rate benefits to the trade and industry to spur the economy. It will indeed be a great challenge for banks to implement the essence of central bank direction in the midst of current proportion of spiralling stressed presently standing at 11.1 per cent in March 2015 moving up from 9.2 per cent in March 2013.

However, some relief is seen for PSBs comes in the form of infusion of capital of Rs 70,000 cr by the government in the next 4 years, a strategic move to improve their fast depleting Capital Adequacy Ratio (CAR). More significantly, PSBs are struck between the pincers of deteriorating asset quality on one side and potential of lowering net interest margins on the other side. They need to balance well with dexterity to operate in the current competitive environment. (The author is Associate Professor, NIBM, Pune. The views are his own)

By Dr K Srinivasa Rao