Thursday, September 3, 2015

Banks cannot delay rate cuts from next year

This year RBI has reduced rates by 75 bps but banks have not passed on the benefit to consumers in equal measure, they have just cut rate by 25-35 bps except the recent move by HDFC Bank.

This was unfair. Costs of funds reduce for Banks whenever RBI reduces rates but they refuse to acknowledge it and instead increase their profit spread. RBI earlier believed that competition will lead to reduction in rates but banks behaved like a cartel and they wanted to increase their profits, probably to offset for bad debts and to reduce provisioning. But this is at the expense of consumer. When RBI raises rates, banks take no time to increase rates but when policy rate is reduced, they do not react even after months!

But this will come to an end. See the latest announcement from RBI. 

It is proposing to revise the guidelines to calculate the base rate in banks. It would be effective from next fiscal year, April 1, 2016. When that happens, banks will have no other option than passing on the benefits to consumers. What is already (40-50 bps cut) due, will be passed on to consumers in few more months.

RBI has said that the thumb rule it follows to set policy rate is, maintaining 1.5% to 2% real rates. If inflation is at 5% and to get real rates of 2%, policy rate will have to be set at 7%. Currently inflation is around 3.8% and is likely to range in 4% to 4.5% seeing the recent trend due to reduction in oil prices. So doing a math for the worst case (4.5% + 2% = 6.5%), there is a scope for reduction of further 75 bps from the current policy rate at 7.25%. In the best case (4%+1.5% = 5.5%), it would be a good 175 bps cut!

Being an inflation hawk, RBI would go slow in cutting rates. But in that case, considering the worst case math, 75 bps cut along with pending 50 bps cut would mean 1.25% reduction in interest rates next year. That is surely good news for borrowers and corporate. EMI on housing loan would reduce by at least 10% as interest outgo reduces (or the loan tenure reduces if EMI is kept the same). For corporate, any saving on capital costs is increase in its earnings.

As deposit rate reduces, real estate may become attractive with the money flowing out of Fixed Deposits and lower EMI making the purchase little affordable. Increasing earnings will help ailing infra companies and their stock market valuation.

Hope this brings revival in housing, auto and consumer goods sector as lower rates would improve demand. And the credit growth in banks which is at multiple years low would also see turnaround. So banks would make up for the loss due to change proposed by RBI with the increased turnover.

But keep in the mind the time line. If RBI acts by next April, it would take 2-3 quarters to translate into demand increase and that would make 2017 a better year. But inflation should not come back before that. Else party will be spoiled as it begins.


  1. As much as the banks cheer about rate cut, the transmission of the rate cut from the central bank to the consumers always takes too much time.

    1. Hi Somaili, that is the reason RBI has come up with this. If you had noticed RBI and banks had duels in the past few months. Banks said their cost of funds has not come down but Rajan said 'it is nonsense!'