Rate cut puts pressure on banks

Cuts in indicative short term interest rates - both lending and borrowing - and Cash Reserve Ratio (CRR) have always - albeit in the recent past - gone hand in hand since the economic slowdown hit the nation. However, when the Reserve Bank of India (RBI) announced a cut in the indicative short-term rates on March 4, sprang a surprise on the markets by not cutting the CRR - a policy initiative that continues to be debated both in the banking and market circles.

Corporate houses and investors alike were without doubt looking forward to a cut in CRR, as such a move would have brought more liquidity into the markets. They were naturally disappointed. However, if the country's apex bank chose not to effect a cut in CRR, it was because of its understanding that banks had enough funds to lend to their customers and they could do without a CRR cut.

Weak rupee
No wonder that the cut in indicative short-term interest rates by the central bank failed to enthuse the bourses, with the benchmark BSE 30-share Sensex tumbling to 3-year closing lows at 8197.92, the next day (March 5), led by banking stocks. Sustained selling by foreign funds, weak rupee and weak European markets weighed on the market sentiment.

On March 4, the RBI cut the short-term indicative rates - repo rate by 50 basis points from 5.5 per cent to 5 per cent and reverse repo rate by 50 basis points from 4 per cent to 3.5 per cent - with immediate effect. Repo rate is the rate at which banks borrow from the central bank, which is an indicative lending rate and the reverse repo is the rate at which banks park their funds with the central bank, which is an indicative borrowing rate.

The RBI's decision to cut the rate was impelled by the deterioration of the global financial and economic conditions since the release of the RBI's third quarter review on January 27, as revealed by the latest available information. The U.S. real GDP contracted sharply at an annualised rate of 6.2 per cent in the fourth quarter of 2008 and the unemployment rate has moved up to 7.6 per cent. The real GDP in the euro area also declined by 1.5 per cent in this period.

Reflecting deteriorating global demand, Japanese exports fell by 45.7 per cent (year-on-year) in January 2009. The Japanese economy also contracted sharply by 3.3 per cent in the fourth quarter of 2008. The fourth quarter real GDP numbers of several advanced economies have turned out to be worse than expected. The uncertainty, therefore, on global recovery has increased.

Global fiscal policies
As a response, the governments all over the world continue to unveil expansionary fiscal policies. Central banks have also taken several measures to stimulate demand and moderate the impact of the global downturn and credit crunch on their economies.

"It is expected that the reduction in the policy interest rates will further encourage banks to provide credit for productive purposes at viable interest rates. The Reserve Bank on its part would continue to maintain ample liquidity in the system," RBI had stated while announcing the latest monetary stimulus. However, the RBI preferred not to cut the CRR, which is the percentage of the deposits banks have to set apart without using for business purposes.

The RBI had a well thought-out plan behind its twin moves - of cutting the indicative short-term interest rates and leaving CRR untouched. On the one hand, the central bank wanted banks to disburse funds to productive sectors of the economy, while on the other, it sent across a message to the market players that there was enough liquidity in the system and it would monitor the use of that liquidity.

The cumulative amount of actual or potential primary liquidity made available to the financial system through various measures initiated by the RBI was over a staggering Rs. 3,88,000 crore. Besides, the reduction in SLR by one percentage point of NDTL has made available liquid funds of the order of Rs.40,000 crore for the purpose of credit expansion. "This sizable easing has ensured a comfortable liquidity position," RBI stated. However, markets ignored all talks on liquidity by the central bank.

Taking a cue from the reductions in the repo and reverse repo rates in recent months, all public sector banks and several private sector and foreign banks have reduced their benchmark prime lending rates (BPLRs). Since the announcement of the third quarter review, eleven banks have cut their BPLRs ranging from 25 to 125 basis points. Several banks have also cut their deposit interest rates.

Even as some public sector and private sector banks have cut lending rates in response to the RBI's monetary policy stance, concerns over rising credit risk together with the slowing of economic activity appear to have moderated credit growth. The RBI urged banks to monitor their loan portfolio and take early action, to prevent asset impairment down the road and safeguard the gains of the last several years in improving asset quality.

"At the same time, banks should price risk appropriately and ensure that creditworthy enterprises continue to get funding,"RBI pointed out. All these measures and talks, however, are not resulting in credit offtake. There are sectors, which still need funds and growing, for example consider power sector. But bankers are not willing to lend and only few consumers are willing to borrow.

The RBI is expecting that the rate cut would put pressure on banks to lend additional funds at a lower interest rate. The cut in indicative deposit rate (reverse repo) to 3.5 per cent is identical to the rate at which banks mobilise savings deposits. In such a scenario banks would find it difficult to park their surplus funds with the central bank and tempted to lend more to individuals and corporate houses.

Excessive volatility
As uncertainty continues in global economic scenario foreign funds are dumping stocks and this put further pressure on the Indian rupee. Interestingly on the previous day (March 3) of the announcement of last rate cuts, the RBI had warned the markets by saying that "the market developments were being monitored and the central bank's policy was to manage excessive volatility". The weak stock market affected the Indian currency and a stronger dollar overseas added to the downward pressure on the rupee.

The RBI understands that risk management is a difficult task for banks even in normal circumstances; it is even more challenging in an environment of uncertainty and downturn.

However, the RBI believes that it has to "take calibrated monetary policy actions as necessary and at the appropriate time" to maintain the flow of credit to productive sectors.

The moral of the story is: the RBI is effectively controlling liquidity in the market and that it does not want to give an opportunity or a situation to the market players to exploit the excessive liquidity - if there at all be in the market - for speculative purposes. Source: Hindu

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