The RBI governor, Raghuram Rajan, kept his word of easing monetary policy early this year and cut the key repo rate—rate at which banks borrow short term funds from the RBI—by 25 basis points on Thursday. Outside the policy review cycle, the RBI’s surprise rate cut clearly signals its growing comfort with falling inflation. For borrowers, this move is positive on two counts. One, it now clearly signals a shift in the RBI’s policy stance, and implies the beginning of a rate cut cycle.
Two, while the 25 basis point cut in repo rate, in itself is not a game changer, it sets the direction of rates and gives banks some headroom to lower lending rates in the next couple of months. Banks which have already seen their cost of funds decline over the past year may now be forced to pass on some of the benefit to borrowers.
Thanks to ample liquidity, banks’ costs of borrowings had already started to cool off, falling 30-40 basis points since January last year. This along with slowing credit growth has prompted banks to lower their deposit rates in recent months.
Now, with the cut in repo rate, the cost of banks’ borrowing can fall by another 20-25 basis points. Over the last one year, the RBI has capped the amount banks can borrow under the fixed repo window, and instead, made good the shortfall by term repo auctions (conducted for 7 and 14-day periods). The cut-off rate for such term repos is now almost in sync with the policy rate. Assuming that liquidity will remain ample in the system, the rate for term repos will also fall by another 20-25 basis points, leading to lower cost of borrowings for banks.
Lower lending rates, with a lag
While this will set the direction for lower interest rates, a lot sooner than expected, the full transmission of this to borrowers will come with a lag and in pockets. This is because banks decide their lending rates based on base rates, which are in turn determined by each bank based on cost of funds, administrative costs and profitability. Also as banks source only a minuscule portion of their funds from the repo window, a widespread cut in lending rates is unlikely.
That said some banks such as SBI, ICICI Bank and HDFC Bank that have the lowest base rate currently (at 10 per cent), may be the first ones to cut base rates. This is because these banks have already lowered rates on their deposits. They will also be able to re-price their deposits faster in a declining interest rate scenario.
More room for a bond rally
The bond market has already rallied over the last one year on hopes of a rate cut. Losing about 100 basis points over the past year, the yields on 10-year G-Sec, has been trading below the RBI’s key policy rate since the December policy review. The policy rate cut on Thursday saw bond markets rally further, with yields falling by 10 basis points to 7.68 per cent, still lower than the repo rate (now) at 7.75 per cent. This clearly indicates that the market is factoring in more rate cuts. While bond markets will continue to rally over the next year, the pace may not be as sharp and quick as seen in the last one year.