With the repo rate being lowered by 125 basis points (bps) within this year and bank lending rates coming down, there is strong reason to believe that lending should pick up substantially, according to conventional wisdom. In this context, it is useful to see how the system has reacted in the past to the lowering of the repo rate.
Data for the last 15 years reveals an interesting picture. Growth in credit tended to be the highest when the repo rate was increased. During FY10-12, it averaged 18.8% when the repo rate was increased by 350 bps to 8.5%. In FY19, when the rate was increased from 6 to 6.25%, credit grew by 26.6%. The next highest growth rate was in FY24, when the repo rate was increased by 250 bps as credit grew by 17.8%.
Rate cuts fail to lift credit
Reduction in repo rate in phases such as FY13, FY14-18, and FY19-22 did not witness an upsurge in bank credit growth. The last period was during the Covid-19 phase as banks went all out to provide credit to customers with several schemes also being engineered by the government through the guarantee and targeted repo operations. Yet, growth tended to be sluggish—merely 6.8%.
The answer really lies in demand for credit. Entities borrow money only when there is a necessity. Therefore, a deep dive shows, there have been differential responses across sectors to the repo rate changes. Industry has responded with less alacrity when demand for their products was sluggish, meaning there was spare capacity in several segments. However, when credit growth was high in periods of high repo rates, it did not matter really as the economy was doing very well and there were fresh capacities planned, especially in the heavy industries for the future.
Double-digit growth in credit to industry was witnessed till FY14, after which there was a distinct slowdown, especially after the Reserve Bank of India introduced the asset quality review in the light of high non-performing assets in the banking sector. Not surprisingly, growth in credit to industry (dominated by large corporates) has never crossed the double-digit mark subsequently. The micro, small, and medium enterprises, however, have witnessed a credit boom due to the myriad policies introduced to channel credit to this segment.
It can be concluded that borrowings by industry will be linked to excess capacity in companies and overall demand outlook. While the corporate debt market has become popular in the past five years, more than two-thirds of the issuances (and at times close to 80%) gets accounted for by the financial sector. It is not that there has been any major migration across markets. The important thing is that spare capacity does not provide an incentive to invest in more machinery, and this also gets reflected in the gross fixed capital formation rates, which have remained around 27-30% since FY15. It was only post-Covid-19 that this rate crossed the 30% mark.
In parallel, an interesting finding is that the retail segment has been more buoyant when it comes to growth in credit, and the response to interest rate changes has been more than commensurate. A double-digit growth rate was consistently maintained through this period, with growth being very impressive post-FY19, when the External Benchmark Lending Rate scheme came in. With retail loans being linked to an external benchmark, any reduction in interest rate has led to higher growth in retail loans.
While this is the historical context, the trends in the current year need to be examined. The 125-bps cut in repo so far this year has lowered the cost of all retail loans by a similar amount. There was an additional booster for consumption in the form of lower goods and services tax (GST) rates. This did lead to retail loans increasing by almost 14% in October (12.9% last year). The interesting aspect here is that within this category, auto loans witnessed a higher growth rate, which matches well with the auto sales reported in the festival season and hence will also get reflected in the November numbers. There was, however, a slower growth for home loans by around 100 bps. This calls for an explanation.
Home vs auto loans-Rate cycle impact
Any borrower whose interest rate is linked to an external benchmark is aware of the fact that interest would vary with the tenure of the loan. Hence, for a home loan, which is typically repaid in 10-30 years, there will be phases when the rates will go up and others when they go down. Therefore, the feeling of gaining while borrowing at a lower rate does not get converted to a “cost illusion”; which, however, does strike the borrower of a vehicle. Loans are of a lower tenure, say five-seven years, and the interest rate cycle is expected to normally last for two-three years. Thus, there may not be too many changes in the interest rate cycle during this tenure. This is why home loans would be driven more by other factors too, such as cost of dwelling, future income streams, expectations of interest rate movements, etc.
A loan category susceptible to the highest level of “cost illusion” is unsecured personal loans. Here, the rate of interest tends to be higher due to the absence of any collateral. Those who borrow through this channel have a pressing need, and they are willing to pay this cost. The illusion sets in when the rates are lowered, as there is a feeling that money is coming cheap.
The big push given by the fiscal reforms on income tax and GST should hopefully increase demand and lead to better capacity utilisation as well as investment. This should increase growth in credit to industry—especially large companies. But for acceleration to take place, overall buoyancy in the economy would be required, which is expected in the next two-three years. Interest rates do affect growth in credit, but may not be the clinching factor as the demand for the end products—which can be machinery, automobile, home, or personal—has to be backed up by consumption.
The author is Chief Economist, Bank of Baroda
Views are personal
