While the RBI’s future action is contingent on fuller transmission, banks are unlikely to be on on an over-drive in cutting lending rates.

The RBI governor Raghuram Rajan’s move to keep key repo rate unchanged, in its third bi-monthly policy review on Tuesday, was in line with most expectations.

The repo rate — at which banks borrow short term funds from the RBI — remains at 7.25 per cent. Like in the previous policy, the RBI continues to maintain its policy easing stance, and has indicated that further cuts will be contingent, among other things, on the trajectory of inflation.

But the RBI has once again, nudged banks to hurry up with their transmission of lower policy rates to borrowers. This means that the RBI is likely to adopt a wait and watch approach before resuming its rate cuts. But banks that have already lowered their lending rates by about 30 basis points are unlikely to yield further. For borrowers this means that rates will soften only gradually over the coming months.

Can banks bridge the gap?

The RBI’s rate cuts since January, have set the direction for interest rates. Banks, that were dragging their feet till March, started to trim their lending rates. On an average, banks have reduced their base rates — to which all lending rates are pegged — by 25-30 basis points. But this is still far lower than the 75 basis points cut that the RBI has made in its policy rate since January.

The RBI has again urged banks to pass on more rate cuts to borrowers. But the transmission of RBI’s rate action to borrowers will come with a lag and only partially — as it has been in the past.

Consider for instance, the period between September 2008 and September 2009 when the RBI had slashed the repo rate by a tidy 425 basis points. But what fell into borrowers’ lap was a mere 120 basis points cut in lending rates. Or the period between March 2012 and June 2013, when repo rate fell by 125 basis points. Only a fifth or 20 basis points of this rate cut was passed on to borrowers.

Done for now

This time around, almost half of the RBI’s rate cut has been passed on to borrowers. Considering the portion of banks’ funding that can be re-priced, the transmission done so far, is good enough.

One of the main reasons for slower transmission has always been that banks source only a small portion of their funds at the repo rate.

Repo rate changes also affect other short-term borrowings of banks. But banks’ dependence on deposits with maturities of less than one year has been falling in the last couple of years. With banks now relying significantly on longer term deposits, changes to interest rates thus don’t immediately reduce their costs. Only about 50-60 per cent of banks’ funding gets re-priced, currently. The RBI’s 75 basis point cut in repo rate, (at 50 per cent) then has been fully transmitted by banks.

Some respite

However, one of the factors that could aid further rate cuts — by smaller 5-10 basis points — is the ample liquidity in the system. Thanks to reduction in demand for currency, increased spending by the Government and lower credit demand, the liquidity in the banking system has substantially improved in the last two months. Credit growth stands at about 9.4 per cent, while deposit growth is a tad higher at 11.7 per cent.

The liquidity situation also determines the pace of transmission. Ample liquidity can provide headroom for banks to lower their deposit rates, which will help bring down their cost of borrowing. Banks have been lowering their deposit rates across time-frames by 50 to 75 basis points in the last 6-8 months. Some have even slashed deposit rates by close to one percentage point.

But this is only because of slack credit demand. Once credit growth starts to pick up, banks are unlikely to lower deposit rates aggressively.

The government has also kept rates on small savings schemes unchanged this year. This is likely to limit the cut in deposit rates beyond a point, as banks will be unable to compete with these schemes that offer much better post tax returns.

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