Economic discussions these days are invariably related to financial markets and ultimately come back to the banking sector’s doorstep. The latest cause for worry is that deposits are not rising at the same pace of credit. Meanwhile, there are concerns over rising repo rate hitting investment.

The increase in deposits since the beginning of the year to November 4 is around ₹9.04 lakh-crore while credit is up ₹10.34 lakh-crore. At the same time the central bank is concerned that while the repo rate has gone up by 190 bps, the deposit rates have remained rather sticky (weighted average rate changed by 35 bps between May and September) which in turn has caused deposit growth to slow down. The weighted average lending rate on new loans has increased by 108 bps while the same for the entire portfolio by 51 bps. What does one make of this situation?

Theoretically, when the central bank increases the repo rate or the monetary policy rate, growth in credit has to slow down as the cost of borrowing goes up and people borrow less. If this does not happen there is a problem with monetary policy efficacy.

Therefore, when we talk of the Fed raising rates to slow down the economy, it can be effective only in case firms borrow less leading to fewer homes being bought. It is expected to lead to cautious investment by companies given the high borrowing costs. This holds good for India too.

Rate hike impact

Hence if the RBI has been raising rates, economic activity should slow down as borrowing comes down. Logically, then growth in credit has to slow down to vindicate monetary policy decisions. The RBI has made this transmission partly automatic by linking certain loans to an external benchmark which is largely the repo rate and at times the treasury rates. And this will carry on until inflation comes down.

Theory says that by raising rates, demand comes down for homes and tepid investment will lower demand for steel, cement, use of credit cards, plastics, chemicals etc, that will slow down price increases and hence inflation. This should play out in the system.

The transmission process deserves some thought. By having some loans linked to the external benchmark the transmission of repo rate hikes becomes automatic. However, bank deposits are based on fixed contracts. Thus even if deposit rates rise, they would apply only to future deposits and the existing deposits don’t get impacted.

Once they come up for renewal, they would be repriced at the new rate. Therefore, there will always be sluggishness in upward movement of bank deposit rates. Customers are rarely flexible when it comes to switching banks and tend to remain with the existing bank. New deposits, however, could be in new banks offering higher rates.

Now, loans which are not linked to the external benchmark would be reckoned at the MCLR which is calculated as marginal cost of new funds. Here the critical aspect is how banks change deposit rates. Banks need to constantly look at the asset and liability maturity profile while pricing deposits.

Further, there has to be an informed decision taken on future of interest rates. Are we sure that the RBI will keep increasing the repo rate or will there be a reversal once inflation comes down?

It is likely that after inflation falls below 6 per cent the repo rate will be lowered. In such a case the loans at repo rate will yield lower returns. It has been seen that banks are selectively increasing deposit rates in certain maturity buckets and not making it a general increase. This way they would not lock in deposits at high rates for long-term deposits.

The MCLR, which is driven by a formula, automatically does not show a commensurate increase in cost. Therefore, the MCLR increase is lower again. The anomaly here is that the retail segment and SMEs borrow normally at the repo based rate and end up paying a higher price. Corporate loans are linked to the MCLR and do not get impacted that much. This explains the transmission conundrum.

Under normal conditions, in the next couple of months the gap between deposits and credit growth should decrease as the former increases and the latter slows down.

But the fundamental problem is the state of financial savings in the economy.

Today it has been observed that consumption has been rising for the first seven months of the year as evidenced by the growth in GST collections.

But inflation has been relentlessly high for the last 10 months. This means that as households keep spending on consumption which is at a higher price, less is left for savings. Here allocation of resources into different channels is important. The stock market has done well since the pandemic. Mutual funds offer a balance between direct and indirect investment in the market.

Indian ‘QE’

Since the pandemic set in the RBI policy has focussed on maintaining growth and so the repo rate was set at a low level of 4 per cent over an extended period of time, deposit rates had come down to the range of 5-5.5 per cent when inflation had been ruling at over 6 per cent. So households naturally moved away from bank deposits to other avenues to protect their real returns.

This has been the fallout of our version of monetary easing where the savers bore the brunt of low interest rates. The low interest rate environment did not lead to higher offtake of credit as demand was selective and banks were cautious. Now with conditions normalising the contradictions are playing out. This is the pain involved in moving back to a new equilibrium.

So the combination of unusual monetary policy followed during the pandemic combined with high consumption at the cost of savings has contributed to the present disruption which will get ironed out as monetary policy works through the system. This can take some time.

The writer is Chief Economist, Bank of Baroda. Views expressed are personal

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