Newspaper editors are great believers in Newton’s third law of motion i.e. every action has an equal and opposite reaction. So if the Reserve Bank of India (RBI) governor Duvvuri Subbarao cut the repo rate by 0.25%, it should immediately translate into banks cutting interest rates on their loans as well. Repo rate is the interest rate at which RBI lends to the banks.
So if you are the kind who still reads newspapers you would have come to the conclusion by reading today’s edition of almost any newspaper that equated monthly instalments(EMIs) on loans are about to take a dip. The logic being that now that the RBI has cut the repo rate and that will lead to banks cutting the interest rates on their various loans as well and passing on the benefits to their current consumers and prospective customers.
Now only if it was as simple as that. Lets try and understand why.
The basic business model of any bank is very simple. It raises money as deposits at a certain rate of interest and then lends it out at a higher rate of interest. The difference in interest rate at which it lends and the interest rate at which it borrows is the money that a bank makes.
So for a bank to be able to cut interest rates on its loans it should first be in a position to cut interest rates on its deposits. Now this is where things get interesting.
The loans of banks (non food lending i.e.) over the last one year (between January 13, 2012 and January 11, 2013, which is the latest data available) have grown by around 15.7%. During the same period the deposit growth of banks has been at 12.8%.
Over the last period of the last six months (i.e. between July 13, 2012 and January 11, 2013) the trend is similar. The lending by banks has grown by 6.8% whereas the deposits have grown by 5.1%.
What this means in simple English is that banks are lending money at a much faster rate than they are able to raise through deposits. Hence, money is tight and banks will need to continue offering high rates of interest on their deposits. Given this, they will have to keep charging higher rates of interest on their loans.
And hence lower EMIs won’t be possible despite the firm belief of newspaper editors in Newton’s Third Law of Motion.
What is interesting is that this trend has been playing out for a while now. In 2011-2012 (i.e. the period between April 1, 2011 and March 31, 2012) bank deposits grew by 13.8% whereas loans grew by 16.3%. In 2010-2011 (i.e. the period between April 1, 2010 and March 31, 2011) the deposits grew by 16.7% whereas loans grew by 23.3%.
The other metric to look at here is the incremental credit deposit ratio. For the period of the last six months this stands at 99.3%. This means that for every Rs 100 that the bank has raised as a deposit in the last six months it has given out Rs 99.3 as a loan.
Now this is a problematic situation to be in. For every Rs 100 raised as a deposit the bank has to maintain a statutory liquidity ratio of 23% i.e. invest Rs 23 in government bonds. Governments bonds are basically bonds issued by the central government to finance its fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends.
Banks also needs to currently maintain a cash reserve ratio of 4.25% with the RBI i.e. for every Rs 100 raised as a deposit the bank needs to maintain Rs 4.25 with RBI as a deposit. The CRR will come down to 4% from February 9, 2013.
So what does this mean? It means that for every Rs 100 raised as a deposit Rs 27.25 (Rs 23 + Rs 4.25) cannot be given out as a loan. The remaining Rs 72.75 (Rs 100 – Rs 27.25) can be loaned out. Even there the bank needs to maintain some cash in its vaults to pay people who may be withdrawing money from the bank.
So given all this for every Rs 100 that a bank raises as a deposit it can basically loan out around Rs 65-70. But in the last six months the banks have loaned almost every rupee that they have raised as a deposit.
How has that been possible? That has been possible because banks have been withdrawing money that they have invested in government bonds in the previous years and giving that money out as loans.
This is something that may not be possible forever because banks needs to maintain a SLR of 23%. They can’t go below that. As T N Ninan wrote in the Business Standard sometime back “In the last two of these years, the credit growth rate (i.e. the loan growth rate) outpaced that of deposits; as should be obvious, this cannot go on indefinitely. And here’s the thing; nearly 40 per cent of the lower credit growth over the past year has been financed by a drop in banks’ investment in government securities; so a good bit of the money that has been lent has not come from customer deposits. Banks could continue to pull money out of government securities, but if they did that the government would not be able to finance its deficit.”
In this scenario where banks are lending out almost every bit of the money they are raising as deposits it is difficult for them to cut interest rates on their deposits and hence on their loans.
The only way bank interest rates can come down is if the government borrowings come down. And that is only possible if the government is able to manage its burgeoning fiscal deficit. Whether that happens on that your guess is as good as mine.
Meanwhile, newspaper editors will continue to believe in Newton’s third law of motion.
The article originally appeared on www.firstpost.com on January 30, 2013, with a different headline
(Vivek Kaul is a writer. He can be reached at [email protected])
As I sit down to write this it is a rather cloudy, dull and insipid morning in Mumbai. An old Tamil number Vaa Vennila composed by the music maestro Ilaiyaraaja and sung by S P Balasubrahmanyam and S Janaki, is playing in the background. I happened to discover this song a few days back, quite by chance, and it has been playing nonstop on my laptop since then. It’s the most melodious composition that I have heard in a long-long time.
Dear Reader, before you start breaking your head over why am I talking about an old Ilaiyaraaja number, when the headline clearly tells you that I should be talking about other things, allow me to explain.
For a music director to be able to create melody a lot of things need to come together. First and foremost the tune has to be good. On top of that the musicians have to be able to flesh out the tune in a way that the music director had originally envisaged it. The lyrics need to make sense. The singers need to get the right emotion into the song and of course not be out of tune. The director of the movie needs to have the ability to recognize a good song when he hears one and not fiddle around with it. And so on.
The point I am trying to make is that “melody” cannot be created in isolation. A lot of things need to come together to create a melodious song and to have an individual born and brought in erstwhile Bihar of Kashmiri Pandit parents, who does not speak a word of Tamil (and not much Kashmiri either), humming it nearly 26 years after it was first released.
What is true about Ilaiyaraaja’s ability to create melody is also true about the ability of Duvvuri Subbarao, the governor of the Reserve Bank of India(RBI), to influence the Indian economy and take it in the direction where everyone wants him to.
The inflation number
The wholesale price index (WPI) inflation number for the month of June 2012 was released sometime back. The inflation has fallen to 7.25% against 7.55% in the month of May. The number has come in much lower than what the analysts and the economists were expecting it to be.
This is likely to lead to calls for the Reserve Bank of India (RBI) RBI to cut the repo rate.
The first quarter review of the monetary policy of the RBI is scheduled on July 31,2012. Industrialists, economists and analysts would want the RBI to cut the repo rate on this day. The repo rate is the interest rate at which RBI lends to the banks.
The first quarter review of the monetary policy is scheduled on July 31,2012. Industrialists, economists and analysts want the RBI to cut the repo rate on this day. The repo rate is the interest rate at which RBI lends to the banks.
So what is the idea behind this? When the RBI cuts the repo rate it is trying to send out a signal to that it expects the interest rates to come down in the months to come. If the banks think that the signal by the RBI is credible enough then they lower the interest rate they pay on their deposits. They also lower the interest rates they charge on their long term loans like home loans, car loans and loans to businesses. With people as well as businesses borrowing and spending more it is expected that the slowing economic growth will be revived.
That’s how things are expected to work in theory. But economic theory and practice do not always go together. The trouble is that even if the RBI cut the repo rate right now, the credibility of the signal would be under doubt, and banks wouldn’t cut interest rates. This is primarily because like Ilaiyaaraja, Subbarao and the RBI also do not work in isolation.
More loans than deposits
The incremental credit deposit ratio of the banks in the six month period between December 30,2011 and June 29,2012, has been 108%. What this means that during this period for every Rs 100 that banks have borrowed by raising deposits, they have loaned out Rs 108. Hence, banks have not been able to match their deposits to loans. They have been funding their loans out of deposits they had raised in periods previous to the six month period considered here. Given the shortage of deposits that banks are facing it doesn’t make sense for them to cut the interest rates on their deposits, even if the RBI were to go ahead and cut the repo rate. And if they can’t cut interest rates on their deposits there is no way the banks are going to cut interest rates on their loans. But why are banks facing a shortage of deposits?
The oil subsidy for this year is already over
The budget for the year 2012-2013 had made a provision of Rs 43,580 crore for oil subsidies. This provision is made to compensate the oil marketing companies (OMCs) Indian Oil Corporation, Bharat Petroleum and Hindustan Petroleum, for selling diesel, kerosene and LPG at a loss. Four months into the financial year the government has already run out of this money. The government has compensated the OMCs to the extent of Rs 38,500 crore for products at a loss in the last financial year (i.e. the period between April 1, 2011 and March 31,2012). This payment was made in this financial year and hence has been adjusted against the Rs 43,580 crore provisioned against oil subsidies in the budget for the current financial year.
The OMCs continue to sell these products at a loss. In the month of April 2012 they lost around Rs 17,000 crore by selling diesel, kerosene and LPG at a loss. In the last financial year the government compensated 60% of this loss. The remaining loss the government forced the oil producing companies like ONGC and Oil India Ltd, to compensate. So using the rate of 60%, the government would have to compensate around Rs 10,200 crore for the losses faced by the OMCs in the month of April. Add this to the Rs 38,500 crore of payment that has already been made, we end up with Rs 48,700crore. This is more than the Rs 43,580 crore that had been budgeted for.
The OMCs continue to lose money
The losses made by OMCs have come down since the beginning of the year. In April, the OMCs were losing Rs 563crore per day. A recent estimate made by ICICI Securities puts the number at Rs 355crore per day. At this rate the companies will lose around Rs 130,000 crore by the end of the year. Even if oil prices were to continue to fall the companies will continue losing substantial amount of money.
All this will mean an increase in expenditure for the government as it would have to compensate these companies to help them continue their operations and prevent them from going bust. An increase in expenditure would mean an increase in the fiscal deficit. Fiscal deficit is the difference between what the government spends and what it earns. The fiscal deficit for the current year has been budgeted to be at Rs 5,13,590 crore. It is highly unlikely that the government will be able to meet this target, given the continued losses faced by the OMCs.
Further borrowing from the government would mean that the pool of savings from which banks and other financial institutions can borrow will come down. This means that to banks will have to continue offering higher interest rates on their fixed deposits and hence keep charging higher interest rates on their loans.
The consumer price index (CPI) inflation for the month of May stood at 10.36%, higher than the 10.26% in April. This is likely to go up even further in the days to come. The WPI inflation coming for the month of June has come in at xx%. And this is likely to push the CPI also in the days to come. CPI inflation will be pushed further given that the government increased the minimum support price on khareef crops from anywhere between 15-53% sometime back. These are crops which are typically sown around this time of the year for harvesting after the rains (i.e. September-October). The MSP for paddy (rice) has been increased from Rs 1,080 per quintal to Rs 1,250 per quintal. Other major products like bajra, ragi, jowar, soybean, urad, cotton etc, have seen similar increases. Also, after dramatically increasing prices for khareef crops, the government will have to follow up the same for rabi crops like wheat. Rabi crops are planted in the autumn season and harvested in winter. This will further fuel food inflation. Food constitutes around 50% of the consumer price index in India. In this scenario of higher inflation it will be very difficult for the RBI to cut the repo rate. And even if it does cut interest rates it is not going to be of any help as has been explained above.
The way out of this mess is rather simple. Oil subsidies need to be cut down. That is the only way the government can hope to control its fiscal deficit. If things keep going the way they are I wouldn’t be surprised if the fiscal deficit of the government even touches the vicinity of Rs 6,00,000 crore against the budgeted Rs 5,13,590 crore.
Only once the government gives enough indications that it is serious about controlling the fiscal deficit, will the market start taking the interest rate policy of the RBI seriously. Before that even if the RBI were to cut interest rates it wouldn’t have an impact.
For Duvvuri Subbarao to make melody like Ilaiyaraaja does a lot of things which are not under his control need to come together. Ilaiyaraaja has control over the people he works with. He can tell his musicians what to play. He can ask his singers to sing in a certain way. He can ask his lyric writer to write a certain kind of song. And so on. Subbarao does not have the same control over the other players in the economy.
So in the meanwhile it is safe to say that try he might as much to make melody like Ilaiyaraaja, chances are he is likely to come up a song Baba Sehgal once made. It was called “Main Bhi Maddona”. For those who have heard the song will know that melody has never been “murdered” more.
(The article originally appeared on www.firstpost.com on July 16,2012. http://www.firstpost.com/economy/post-wpi-subbaraos-music-may-be-more-baba-sehgal-than-ilaiyaraaja-378448.html)
Vivek Kaul is a writer and can be reached at [email protected]
Decisions are of two kinds. The right one. And the one your boss wants you to make. The twain does not always meet.
Duvvuri Subbarao, the governor of the Reserve Bank of India(RBI), earlier this week, showed us what a right decision is. He decided to hold the repo rate at 8%. Repo rate is the interest rate at which RBI lends to banks. There was great pressure on the RBI governor to cut the repo rate, after the gross domestic product (GDP) growth for the period between January and March 2012 came in at a very low 5.3%.
The Finance Minister, Pranab Mukherjee, declared openly that he was “confident that they (the RBI) will adjust the monetary policy,” which basically meant that he was ordering the RBI to cut the repo rate. The idea was that once the RBI cut the repo rate, banks would also cut interest rates leading to consumers borrowing more to buy homes, cars and durables. Businesses would borrow more to expand and in turn push up economic growth.
But economic theory and practice are not always in line. Subbarao, probably understands this much better than others, though until very recently he had largely stuck to doing what his boss the Finance Minister, wanted him to do. For the first time he has shown signs of breaking free.
The credibility of a repo rate cut
By cutting the repo rate the Reserve Bank essentially tries to send out a signal to banks that it expects interest rates to come down in the days to come. If banks think the signal is credible enough then they cut the interest rates they pay on their deposits as well as the interest rates they charge on their long term loans like home loans, car loans and loans to businesses. But the trouble is that even if the RBI cut the repo rate, the credibility of the signal would be under doubt, and banks wouldn’t have been able to cut interest rates.
Between the six month period of December 2, 2011, and June 1, 2012, banks have given loans amounting to Rs 4,46,563 crore and have borrowed Rs 4,27,709 crore. Hence for every Rs 100 that the banks have borrowed they have lent out Rs 104, which means they have not been able to raise enough deposits during to match their loans. So their ability to cut interest rates is limited. The question is why is the money situation so tight?
High fiscal deficit
The government of India has been running a very high fiscal deficit. For the financial year 2007-2008, the fiscal deficit stood at Rs 1,26,912 crore. It shot up to Rs 5,21,980 crore for 2011-2012. In a time frame of five years the fiscal deficit is up nearly 312%. The income earned by the government has gone up by only 36% to Rs 7,96,740 crore, during the same period. The huge increase in fiscal deficit has primarily happened because of the subsidy on food, fertilizer and petroleum. For the current financial year, the fiscal deficit is projected to be at Rs 5,13,590 crore, which is likely to be missed as has been the case in the last few years. The oil subsidy targets have regularly been overshot. This year the government might even overshoot the food subsidy target of Rs 75,000 crore.
The government finances its fiscal deficit by borrowing. When a government borrows more, as has been the case for the last few years, it ‘crowds out’ the other big borrowers like banks and corporates. This means that the ‘pool of money’ from which banks and companies have to borrow comes down. Hence, they have to offer a higher rate of interest. This is the situation which prevails now. So banks will continue in the high interest rate mode.
What must have also influenced Subbarao’s decision is the high inflationary which prevails. The consumer price inflation for the month of May stood at 10.36%. This is likely to go up even further in the days to come given that the government recently increased the minimum support price(MSP) on khareef crops from anywhere between 15-53%. These are crops which are typically sown around this time of the year for harvesting after the rains. The MSP for paddy (rice) has been increased from Rs 1,080 per quintal to Rs 1,250 per quintal. Other major products like bajra, ragi, jowar, soybean etc, have seen similar increases. This will further fuel food inflation. Also, after dramatically increasing prices for khareef crops, the government will have to follow up the same for rabi crops like wheat. Rabi crops are planted in the autumn season and harvested in winter. Economists expect higher MSP on agriculture products to push up the food subsidy bill by Rs 40,000 crore from its current level of Rs 75,000 crore. This means a higher fiscal deficit and in turn higher interest rates.
In a scenario where the inflation is over 10%, cutting interest rates can fuel further inflation, which isn’t good for anyone. The RBI in a release said that the inflation is “driven mainly by food and fuel prices.” That’s something Subbarao cannot do anything about and is for the government to sort out.
“In the absence of pass-through from international crude oil prices to domestic prices, the consumption of petroleum products remains strong…preventing the much needed adjustment in aggregate demand,” the RBI release said. The Subbarao led RBI seems to be clearing telling the government here to cut down on oil subsidies by increasing fuel prices as and when necessary.
In fact in a rare admission Subbarao even said that the last cut in the repo rate in April may have been a mistake. “The Reserve Bank had frontloaded the policy rate reduction in April with a cut of 50 basis points. This decision was based on the premise that the process of fiscal consolidation critical for inflation management would get under way, along with other supply-side initiatives,” the RBI release said.
What this means in simple English is that the RBI may have been led to believe by the finance ministry that if they went ahead and cut the repo rate in April, the government would follow up by taking emasures to cut the fiscal deficit. But that hasn’t happened. RBI kept its part of the deal. The government did not.
The article originally appeared in the Times of India Crest Edition on June 23,2012.
(Vivek Kaul is a writer and can be reached at [email protected])