When will banks raise interest rates?

October 3, 2010

(D. H. Pai Panandiker is President of RPG Foundation. The views expressed in this column are his own and do not represent those of Reuters.)

By D. H. Pai Panandiker

The RBI has been at it since the beginning of this year. In seven months it raised the repo rate from 4.75 percent to 6 percent. The banks were slow to react to the RBI signal until August. That may not be the end of the initiative and quite likely the rates will be put up once again.

The response of banks to RBI repo rate has seldom been immediate or equivalent whether on the upswing or on the downswing. For instance, when the repo rate was brought down from its peak of 9 percent before the financial crisis to 4.75 percent, the average PLR of banks came down from 13.5 percent to 11.5 percent. The changes in the repo rate have been much sharper and much faster than the interest on bank deposits or credit.

One reason is that nearly 90 percent of the bank deposits are term deposits and about half of the term deposits are for more than one year. Interest on these deposits is contractual and as such the cost of funds to the banks remains fairly steady in spite of the changes in interest rates. But the period of bank credit is generally shorter.

Besides, borrowings under repo auctions fund a small part of the total bank credit. Currently, the repo rate is also less than the rate of interest on deposits and, as such, banks are not disadvantaged by borrowing from the RBI.

Although liquidity position is not presently tight, banks may be induced to go in for rate revision because there is an imbalance between growth in deposits and growth in credit. In 2010, so far, deposits increased 14 percent and credit increased 19 percent.

The slowdown in deposits is partly because of diversion of investment to other securities. To maintain credit growth, banks will have to jack up growth in deposits and, for that, increase rates to keep up with the market. A 25-50 bps increase in rates in the next two months is not unlikely. That would correspondingly push up both the base rate and the PLR.

For more than a year the PLR of most banks had been steady. Banks had pegged their PLR at 11-12 percent until August this year when it was raised by 50 bps.

The demand for credit is strong with industrial production shooting up at more than 13 percent and the housing activity in full swing with projects under construction crossing Rs.4.5 lakh crores for the first time.

An increase in PLR would therefore be absorbed without any resistance from the borrowers. The first category of bank loans that will attract the higher rate will be home loans.

With the readjustment in the base rate and the PLR, interest structure of banks would be more or less the same it was in 2007 when the economy was growing fairly rapidly without getting heated. The interest rates may stabilize at this level for some time unless inflation refuses to budge.

(The above article is not intended to be a financial advisory. Readers must seek specific advice from experts before making investment decisions.)

(You can e-mail Dinker H. Pai Panandiker at: dpanandiker@gmail.com)

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