Interest Rates Are Trending Lower Even Before RBI Has Cut Rates

Effective interest rates on fresh bank loans made in April fell after rising for nearly a year. Easier banking liquidity conditions have also driven interest rate pay-outs on fresh deposits lower, even as rates on already outstanding deposits and loans climbed higher.

Rates on fresh term deposits declined by 12 basis points month-on-month in April, while those on fresh loans fell by 23 basis points, RBI data shows.

Weighted average interest rates on loans and deposits already contracted have registered a month-on-month rise of 12 basis points and 4 basis points, respectively. The weighted average rates on fresh loans and deposits dipped.

This divergence has emerged despite the monetary policy committee keeping the country’s benchmark rates unchanged at its April meeting. The MPC meeting for June is currently underway and concludes on Thursday.

All 18 economists polled by Bloomberg expect the MPC to maintain the status quo on the RBI's repo rate. The benchmark policy repo rate is currently at 6.50%.

Under the external benchmark lending rate, banks typically use the repo rate as the benchmark, with a spread on top to accommodate items such as credit risk premium and operating costs.

For banks, the weighted average lending rate is a measure that reflects the average interest rates charged on all loans, accounting for the individual sizes of the loans; that is, the amount outstanding under a loan is taken as the weight for the loan. Similarly, the weighted average rate on term deposits reflects the average interest yield on deposits, accommodating for their individual sizes.

Underlying this divergence in the movement of fresh and existing interest rates are improved liquidity conditions, softer credit demand, and competitive intensity, according to bankers BQ Prime spoke with.

The banking system's credit growth has been moderating after recording multi-year highs in the financial year ended March 31. In the fortnight ended May 19, outstanding non-food credit rose 15.6% year-on-year. This is lower than the 16% year-on-year credit growth recorded at the end of April.

A handful of large lenders, including Punjab National Bank, Union Bank of India, Axis Bank Ltd., and ICICI Bank Ltd., have lowered rates on certain specific deposits by 5–15 basis points.

"Banks have tweaked their spread over the repo rate to stay competitive," Anil Gupta, co-group head of financial sector ratings at ICRA Ltd., told BQ Prime. Better liquidity conditions and lower returns on money market instruments have eased pressure on bulk deposits, driving interest rates on fresh deposits lower, he said. Bulk deposits are individual deposits above Rs 2 crore.

Significantly improved liquidity conditions have brought down interest rates on bulk deposits sharply, a private banker said on condition of anonymity. This has allowed banks to be more aggressive on the pricing of loans, this person said.

Over the last three working days, the RBI has held three variable-rate reverse repo auctions intended to withdraw liquidity from the system. But all three of the auctions did not witness enthusiastic participation.

Auctions held on Friday and Monday received bids worth 25.4% and 66.6% of the notified amount, respectively, whereas the auction held on Tuesday received bids worth 43% of the notified amount.

Banks' hesitation about moving excess funds to the RBI also has a tenure component to it. While Friday's auction was a 14-day VRRR operation, Monday and Tuesday were four and three days, respectively.

Banks haven't moved significant liquidity to the RBI over longer tenures due to concerns about a sudden turn in liquidity conditions, a second private banker who spoke on the condition of anonymity said.

Earlier in May, a drop in system-wide liquidity caused overnight financing rates for banks to climb above the repo rate, but they have since eased to a weighted average of 6.30% as of Tuesday.

Relatively lower credit demand in April has also driven interest rates lower on the lending side, the second private banker said.

The housing segment remains competitive and has also seen a slowdown in demand, so banks have lowered rates in the segment, as the first private banker mentioned above said. Elevated interest rates in the segment, compared to last year, have driven the slowdown in demand, this person said.

Pricing room in the corporate loan segment is tight and growth is tepid, which gives limited room for interest rates to move up, according to a third banker who also spoke on the condition of anonymity. Although the RBI's decision to scrap Rs 2,000 notes from circulation came after April, it is expected to bolster liquidity further, this person said.

The compression in yields on fresh deposits and loans is likely to continue in the near term, Gupta of ICRA told BQ Prime. Later in the year, when liquidity gets tighter, short-term funding costs for banks could move up again, he said.

Banks will also be closely listening to the MPC meeting's outcome on Thursday for policy language surrounding the benchmark rate and liquidity conditions.

If the RBI seems to be comfortable with inflation and indicates that 6.5% on the repo rate is the peak, then they might be comfortable leaving some excess liquidity in the system, as the first private banker mentioned above said. But if they continue to be cautious, they will clearly suck out the liquidity from the withdrawal of the Rs 2,000 note, according to this person.

While dropping interest rates at a time of steady policy rates can present a challenge to the transmission of monetary policy, bankers don't expect existing conditions to pose trouble for the RBI's objectives.