Whenever RBI reduces its Repo Rate, there is a widespread demand for reduction of Base Rate by banks in India. The media also gives greater publicity to changes – particularly reductions - in Repo Rate. There is a tremendous pressure from Ministry of Finance and RBI too on the banks to reduce their Base Rate, as when a reduction effected in Repo Rate by RBI.
Let’s see how far the RBI’s Repo Rate impacts the interest rates of scheduled commercial banks – be it in private sector or public sector.
Statutory Reserve Requirements
As per Sec. 42(1) of RBI Act, 1934, all scheduled commercial banks in India are required to keep a portion of their Demand and Term Deposits with RBI. This mandatory deposit with RBI will act as emergency cash reserve, so as to ensure short term liquidity of the banks.
RBI has powers to stipulate any CRR without any floor or ceiling rate.
At present, the CRR stands at 4% and banks do not earn any interest on deposits parked with RBI for CRR purpose.
To the extent of CRR, banks’ loanable funds are brought down. In other words, out of every deposit of Rs.100, banks have to earmark Rs.4 towards CRR and this will be an idle reserve generating ‘zero income’.
In addition to CRR, all banks in India have to invest a portion of their demand and term deposits in gold, cash and other approved securities. Percentage of this additional reserve is known as ‘Statutory Liquidity Ratio’ (SLR) and it is imposed on banks in accordance with Sec.24 of Banking Regulation Act, 1949.
While RBI has powers to fix SLR at the maximum level of 40%, the present SLR is at 21.50%. Here, only cash balances over and above the mandatory CRR will be reckoned for SLR purpose.
While cash and gold do not generate any income, investments made in approved securities fetch some returns, but they may not be attractive enough.
Thus, to the extent of CRR and SLR, banks’ loanable funds are brought down. In other words, out of every deposit of Rs.100, banks have to earmark Rs.25.50 towards CRR and SLR and only the balance of Rs.74.50 can be given as loans and advances.
Rate of Interest contracted for Term Deposits is fixed and cannot be altered
As we all know, deposits constitute a major source of funds for the banks.
Rate of Interest offered on bank deposits are fixed and cannot be changed until the maturity of such deposits. Thus, cost of funds for a scheduled bank does not change much in the short term.
Whenever the interest rates are falling, it will result in reduction in cost of deposits for the banks. But, since more than 60% of the banks’ term deposits fall in the time bucket of 1 to 3 years, banks do not gain anything in the short term, even in the falling interest rate regime.
When average cost of deposits goes up, banks will be constrained to increase their Base Rate too (Base Rate is the minimum lending rate).
Size of funds mobilised through Repo route is very small
Banks can borrow funds from RBI through Repo window only up to the ceiling of 2% of their net demand and time liabilities.
Funds mobilised through Repo are meant only to bridge the gap in short term liquidity requirements of banks.
Average borrowings made by banks under Repo range only from 0.5% to 1% of their total deposits, at a given point of time.
Thus, size of funds mobilised through repo route, in relation to bank deposits is very small and funds borrowed by banks through Marginal Standing Facility (Repo) create little impact on the average cost of funds of commercial banks.
Play of Market Forces
Since RBI has freed the interest rates, except on DRI advances, each bank enjoys autonomy in fixing their own Base Rate, but it shall be non-discriminatory in nature.
Thus, the business strategies and operational efficiency of each bank will decide its Base Rate. Base Rate undergoes changes many times in a year.
Market forces also greatly influence the interest rates. So, a bank’s average cost of funds alone cannot determine its Base Rate.
Asset Liability Mismatch
As already mentioned, while most of the bank’s term deposits fall in the 1 to 3 years time bucket, the average tenor of bank advances is from 3 to 5 years. Thus, there is a general mismatch in the assets and liabilities of banks.
This is another reason for the banks vying with each other to vigorously go for higher proportion of CASA in their Deposit Mix on an on-going basis (while the primary reason is to bring down the average cost of deposits).
Others
Now, coming to the point, as and when RBI reduces its repo rate, banks cannot immediately pass on the benefits to the borrowers.
No doubt, Repo funds inject further liquidity into the system, but it cannot be said that the economy is willing and capable of increasing their credit off-take.
Credit expansion takes place over a period of time and it cannot happen quickly.
Composition of advances is also a key determinant in credit expansion. Demand for additional credit will vary with different geographical regions and the activities/sectors which are ready to borrow more also vary from one region to another.
To make credit cheaper, banks cannot unilaterally reduce the interest rates on their deposits, as crores of people still depend on interest income for their sustenance.
It will be difficult for the banks to satisfy the aspirations of depositors and borrowers at a time.
Each bank has its own business strategies and priorities. Financial health of each bank also varies from each another. Such being the case, we cannot expect all banks to react in the same way to changes in RBI’s Repo Rate.
Date: 15-06-2015
contributed by. pannvalan
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India’s current account deficit (CAD) reduced to $27.5 billion (1.3% of GDP) in fiscal 2015 from $32.4 billion (1.7% of GDP) in fiscal 2014 largely on account of a lower trade deficit. Thanks to lower oil prices and subdued domestic demand, India’s imports shrank by 1.2% to $460.9 billion in fiscal 2015. While exports too were subdued, they declined by a smaller pace (-0.6%) to $316.7 billion.
Consequently, trade deficit in fiscal 2015 came down to $144.2 billion from $147.6 billion in fiscal 2014. On the other hand, net invisibles grew by 1.2% to $116.7 billion largely on account of a 3.7% rise in net services exports. Software services, which account for more than 90% of net services exports grew by 5.1% to $70.3 billion in fiscal 2015. The second largest component within invisibles – secondary income or gross transfer receipts, representing remittances by Indians employed overseas showed only a modest growth of 0.9% in fiscal 2015 in comparison to 1.5% per year growth in the last 2 years due to subdued global economic environment.
Fiscal 2015 saw robust capital flows into the India economy in the hope of a quick economic turnaround after Modi government was chosen to power last year. While net Foreign Direct Investments (FDI) - the more stable form of investments rose by a healthy51.3% to $32.6 billion in fiscal 2015, net Foreign Portfolio Investments (FPI) grew almost ten-fold to $40.9 billion in fiscal 2015 from $4.8 billion in fiscal 2014. As a result of such large inflows, accretion to India’s foreign exchange reserves jumped almost four times to $61.4 billion in fiscal 2015 from $15.5 billion in fiscal 2014. At the end of March 2015, India’s foreign exchange reserves stood at $341.6 billion which are equivalent to almost 9 months of our imports and leave the central bank in a much better position to address exchange rate volatilities.
Quarterly trend in India’s balance of payment are favourable but suggest caution going ahead. While CAD in Q4 of fiscal 2015 i.e. Jan-Mar 2015 narrowed sharply to $1.3 billion (0.2% of GDP) in comparison to $8.3 billion (1.6% of GDP) in Q3 of fiscal 2015, it was a tad higher than $1.2 billion (0.2% of GDP) CAD in Q4 of fiscal 2014. The sharp reduction in CAD in Q4 of fiscal 2015 was on account of a shrinking trade deficit which came down to $31.7 billion from $39.2 billion in the previous fiscal. Even though exports declined by 10.4% y-o-y in Q4 of fiscal 2015, a much sharper decline in imports (-13.4%) led to the reduction in trade deficit. Net services. The performance of net invisibles, on the other hand, remained subdued in Q4 of fiscal 2015. Net earnings from both services and primary income (which comprise of profit, dividend and interest) were lower when compared to the previous quarter.
Secondary income, which is largely transfers from abroad too recorded only marginal increase of 0.4%. On account of both a lower CAD and healthy foreign capital inflows, Q4 of fiscal 2015 witnessed the highest ever accretion to India’s foreign exchange reserves at $30.1 billion which is almost four times larger when compared to $7.1 billion accretion in Q4 of fiscal 2014.
Outlook: Going ahead, I expect India’s current account deficit (CAD) to rise to 1.5% of GDP in fiscal 2016 from 1.3% of GDP in fiscal 2015. While lower oil prices would help keep oil imports in check, an increase in core (non-oil non-gold) imports on account of improvement in domestic GDP growth would increase the overall import bill. India’s exports, at the same time are expected to remain subdued due to still weak economic outlook for India’s major export markets such as the OPEC economies, China and Eurozone. Capital flows too are expected to be slower and more volatile due to a likely interest rate hike by US Fed in September this year.
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