Following on the heels of the ECB, Bank of England, and other Central Banks, the RBI has finally cut (full text of press release here) the benchmark repo rate by 100 basis points to 6.5% and reverse repo rate by the same margin to 5%. Now that the proverbial horse has been taken to water, the eagerly awaited answer is whether the banks will pass on the benefits to borrowers by way of lower lending rates?
The fundamental problem with the financial markets in India today is the apparent reluctance of banks to lend to businesses. Though the dramatic cuts in reserve ratios and repo rates, LAF auctions, and repurchase of MSS bonds in past few weeks have relased an additional Rs 3,00,000 Cr into to the banking system, not much of this has found its way into financing investments in the economy. Instead, the banks have preferred to invest in the safety of low yielding Treasury securities and the RBI.
There have been many reasons attributed to this reluctance. The uncertainty surrounding the financial markets and the effects of the sub-prime mortgage crisis have become so deep that counter party risks are very high. Safety and not returns have become the first priority for banks.
Another area of concern for the banks is the high cost of their present liabilities, especially with the strong possibility that rates will fall steeply in the coming months. The average cost of working funds for banks is well over 7%, with at least 30-35% of the deposits priced upwards of 9%. The expectations of rate cuts and plummeting equity markets has also led to the shift of assets and cash surpluses by many coporates and Public Sector Units to the safety of bank deposits. The banks too, faced with capital scarcity, have been competing with each other in attracting these deposits, often offering very high rates. The result of this is that many banks may not be in a position to pass on the full beneifts of rate cuts to its borrowers without seriously undermining their balance sheets.
The banks in turn argue that they have not been reluctant, but have been weighed down by the sharply increased demand for funds from the corporate sector which has been squeezed off its other regular sources of funds. Businesses have four major sources of investment funding - equity markets, external commercial borrowings, profits and bank loans. The first two, which formed 40% of the funds for Indian industry in 2007-08, has dried up, while the third is declining with the economy. This has left banks as the primary source of funds, thereby sharply increasing the demand for bank loans (credit growth has been at a scorching annualized rate of 28%). The banks have been clearly unable or unwilling to meet this increased demand, despite the dramatic increase in liquidity.
Here is a brief on the major credit market indicators.
Investors have taken money out of stocks, corporate bonds and money market funds to buy safe assets, thereby forcing down the yields on Treasuries. A declining yield is an indicator of greater concern with the financial markets. The most appropriate measure of the flight to safety is the Statutory Liquidity Ratio (SLR), which is presently in the range of 26%, against the mandatory requirement of only 24% (and effective requirement of only 21.5%).
The reverse repo window of the RBI has been witnessing heightened activity in since the middle of November, with banks queing upto deposit their surpluses for the relatively meagre 6% returns offered. Despite the declining SLR, the investments to deposit ratio for banks has climbed from 28.27% to 30.48% over the past month. In October, banks lent just Rs 27,000 Cr, whereas they invested Rs 90,000 Cr in G-Secs.
Expectations of rate cuts and the hope of making significant risk-free profits (especially at such bleak times) from the greater chances of capital gains from rising bond prices (as rates fall, yields decline, thereby pushing up bond prices) has been another incentive for banks to invest in long dated government securities.
Contrary to conventional bond market wisdom which says that yields rise as maturity lengthens, yield curve had become inverted - long-term yields lower than short-term yields. Inverted yield curves indicate tight immediate credit conditions besides uncertainty about the future. Though it has flattened out in the past few days, the 91-days Treasury Bill and the benchmark Government Security of 10-year residual maturity are both being quoted at the same, around 7% yield, underscoring the deep concerns about declining economic activity.
CP or short term debt issued by the larger private businesses, often for a few days, and purchased mainly by banks and financial institutions, has dried up. This is indicated by the widening spreads between rates on Government securities and CPs of the same maturities. Higher spreads have made it difficult for both businesses and banks to run their daily operations. The CP market has virtually ground to a halt, as the spreads with T-Bills for even AAA rated companies have ballooned to more than 600 basis points.
Call money rates
Overnight rates at which banks borrow capital to meet their daily working capital requirements had reached very high levels of over 24%, indicating the magnitude of the credit crunch. Typically, overnight call money rates move in the band between the repo and reverse repo rates. However, these rates have fallen to around 6% in recent days and the repo auctions under the Liquidity Adjustment Facility (LAF) has stopped attracting bids, an indication of the easing of the liquidity conditions.