Credit Policy : 1996-97 dj vu

Updated: Jul 31 2006, 05:48am hrs
The markets expected the reverse repo rate to be hiked; and the Federal Reserve action, domestic inflation, expected inflation, pick-up in credit etc. were used as justifications for the same. There were no surprises for sure. But, what next is the question

This is the time to introspect because we have reached a situation where the reverse repo rate has been increased at a time when there is surplus liquidity in the system. Are we making life harder for ourselves

There are two issues worth pondering about now. The first pertains to the impact on industrial growth and the second on bank profitability.

It is accepted that inflation can be pre-empted on the demand side by raising interest rates, but cannot be controlled by monetary measures on the supply side. But, by increasing interest rates, we could be attacking growth.

The shadow of the 1996-97 syndrome hangs over us as interest rates have started climbing. Interest rates were raised by the RBI at that time which affected industrial growth as corporates found it difficult to borrow.

The same is possible today especially so since global rates are also high and the ECB market may not be an attractive proposition given the higher global rates and weakening rupee. Further, while corporates may not be affected if they are not in an investment phase or are able to buffer it with aggressive sales, retail lending could be affected negatively. Mortgages, personal and auto loans have been the front liners in the lending profile of banks. Thus, higher lending rates, which are being contemplated today by banks could reduce the demand for such loans and drain the backward linkages with the relevant industries.

Bank profits too would be in for some shock treatment from two ends: spreads and treasury income. The reverse repo rate has superseded the bank rate as the monetary policy measure since October 2003. It was reduced three times till 2004 by 100 bps and then raised gradually by 150 bps in 6 steps. When the rate was lowered, deposit rates fell by 150 bps while the PLR was down by just 50 bps. When the rates were hiked by 125 bps, the deposit rates have gone up by almost 150 bps and lending rates by just 50 bps. Evidently, the lending rates have shown a more gradual hike in a competitive set up.

The pressure on spreads will remain especially so since real deposit rates have to adjust to higher inflation of 5%. Banks may probably have to raise the final lending rates further, especially on the retail end, which would, as explained earlier have repercussions on the manufacturing sector.

It must also be remembered that the FM had spoken of farm loans at 7% at a time when the 1 year deposit rate has averaged 6.65% (prior to the rate hike this time). The other area which can pressurize bank profits would be treasury income. The indicative 10-year yield rate had fallen by 140-150 bps during the downswing in repo rates and has risen by 170-180 bps during the upswing. This will definitely mean less treasury gains this year.

The message for the banks is clear. Thinner spreads and less free riding treasury income will characterize the income sheets in the coming year.