Emerging economies are faced with daunting challenges at a time of ongoing geopolitical risks, heightened global commodity prices and resurgence of Covid in some parts of the world. The hike in US interest rates on March 16, with the indication of more hikes to come, and the eventual liquidity tapering with a halt to bond-buying in the US only adds to the uncertainty.

The hardening of interest rates has become a global trend. The central banks of New Zealand and Canada have raised rates by 25 basis points (bps) each in February and March 2022, respectively. Most EME central banks also continued with their policy rate tightening, including Mexico which hiked its benchmark interest rate by 50 bps in February.

On February 28, in an emergency move, the Bank of Russia increased its key rate by 10.5 percentage points to 20 per cent due to deterioration in the external environment and escalating risks of currency depreciation and high inflation.

On the other hand, the People’s Bank of China paused after two consecutive months of easing while the Central Bank of the Republic of Turkey maintained a pause for the second consecutive month. These global trends affirm impending rate hikes marking the move towards ending the easy money regime.

Hardening rates

The global sentiments of hardening rates have begun to influence domestic banking. The deposit growth in banks is receding and credit growth is rising with the inevitable need to augment additional resources to fund the potential demand for credit, which will tend to push up the rates. This is likely to arrest the decline in deposit growth, which coincided with the drop in rates since March 2020.

As on February 25, the year-on-year (y-o-y) deposit growth slipped from 12.1 per cent to 8.6 per cent whereas credit growth jumped from 6.6 per cent to 7.9 per cent. Retail credit continues to dominate with 37 per cent growth in incremental credit.

Led by the shift in the business mix and changed priorities of resource allocation, banks have begun to raise rates. SBI, HDFC Bank, IDBI Bank and IndusInd Bank have increased their interest rates on fixed deposits by 10-15 bps, while more banks are set to follow suit. With the revival in the credit cycle, fund mobilisation through CD (certificate of deposit) issuances too surged during November 2021-January 2022, up from ₹61,983 crore to ₹65,298 crore during April-October 2021.

Interest rates on longer term money market instruments such as 3-month T-bill and certificates of deposit (CDs), however, remained higher, with their respective spreads over the reverse repo rate averaging 38 bps and 60 bps during the second fortnight of February through March 11, 2022.

Going by the same trend, the yield on the 10-year benchmark G-sec hardened to 6.86 per cent on March 11 from a low of 6.60 per cent observed on February 18. In tandem, the corporate bond yields also hardened, closely following the movement in G-Sec yields. In such hardening trends, banks are scouting alternative sources of funds for effective asset-liability management (ALM).

The extent of pass-through of policy rate reduction to the median term deposit rate (MTDR) which remained 154 bps during the period March 2020 to September 2021, dipped marginally to 150 bps in February 2022, hinting at the hardening of deposit rates. Against the repo rate cut of 115 bps, one-year medium MCLR of banks was pared by 95 bps, currently in the range of 6.45-7 percent.

The weighted average lending rates (WALR) went down by 122 bps, reflecting a considerable pass through of rate cuts. In the meantime, the medium-term deposit rates went down by 150 bps.

Liquidity position

The RBI adopts strategies to rebalance liquidity on a pre-announced glidepath enabling banks to maintain sustainable liquidity conditions in a non-disruptive manner to meet the needs of the productive sectors of the economy. Infusion and absorption of liquidity is maintained and response of banks reflects the pulse of market rates as a natural function of demand and supply of liquidity.

In alignment with the accommodative monetary policy stance, daily liquidity absorptions under the liquidity adjustment facility (LAF) averaged ₹8.4-lakh crore in the second half of February through March 2022 (up to March 13), widening from ₹7.4-lakh crore during the second fortnight of January to mid-February 2022.

When the RBI proposed lending around ₹50,000 crore and went for variable rate repo auction on January 20, the cut-off rates were set at 4.06 per cent, along with weighted average rate of 4.10 per cent and both cut-off rates were above the repo rates.

Similarly, paring of surplus liquidity through Variable Rate Reverse Repo (VRRR) auctions continue to be used for absorption of excess liquidity. In doing so, when a 14-day VRRR auction until December 31 was planned to suck out ₹7.5 trillion, the banks offered only ₹2.67 trillion. On a reverse repo auction on January 14, where the RBI wanted to compensate the shortfall of about ₹5 trillion, the banks yet again only offered ₹4.31 trillion. The cut-off rate of VRRR auction of ₹2 trillion on January 3, was at 3.99 per cent much above the reverse repo rate indicating firming up of rates in the liquidity market.

As the capex and private investment cycle activates, demand for credit could surge. While ramping up lending operations, banks have to shift focus back on aggressive deposit mobilisation and augment current account and savings bank accounts (CASA) to be able to build enough low cost resource base to support credit growth.

With tough times of asset quality woes behind, with National Asset Reconstruction Company (NARCL)-Bad Bank becoming operational and two editions of loan restructuring options provided by the RBI, banks should be in a better position to lend.

The CD ratio of banks in March 2020 (pre-Covid period) was at 76 per cent, which slipped to 71.6 per cent by December 2021. With the economy on a stronger footing (except in high contact sectors) now, the de-leveraged corporate sector and potential MSME sector should be able to open up newer opportunities for banks.

The RBI may continue with its accommodative stance in the upcoming monetary policy in April due to its staunch commitment to support revival of the economy. But the headwinds of domestic inflation, hardening interest rates, impact of rate rise in the US and tapering of liquidity and geopolitical unrest will continue to haunt the policy deliberations.

It can be a matter of debate whether it will begin with a rise in the repo rate.. But, in any case, measures towards normalisation are sure to follow. Banks will have to reinvent their approach towards business growth, managing multiple risks arising from policy actions.

The writer is Adjunct Professor, Institute of Insurance and Risk Management. Views are personal

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