Tuesday, February 1, 2011

The credit-deposit growth rate mismatch

In its third quarter monetary policy review, the Reserve Bank of India, made clear its concerns at rising inflationary expectations by raising the repo and reverse-repo rates by 25 basis points to 6.5% and 5.5% repsectively. It also steeply marked up its March 2011 baseline projection of wholesale price index based inflation to 7% from 5.5%. The monetary tightening comes as the RBI claims that the "balance of risk has tilted towards intensification of inflation".

It also expressed its concerns at "credit growth outpacing deposit growth" and the growing "wedge between deposit and credit growth". Credit growth today is 24.1%, against the indicated projection of 20%, while deposit growth is 16.5%, against the indicated projection of 18%. The RBI Governor has blamed this for the liquidity deficit and asked banks to "increase their deposit rates and restrain their credit".

The aforementioned graphic (of credit and deposit growth rates) indicates a clear stickiness with deposit growth rates over an entire cycle. Over all of 2009, the lending growth rates dropped steeply in response to the weaker global economic cues, loose liquidity conditions and central bank's monetary accommodation. This year, with the domestic economy back to full steam, credit growth naturally followed the upward course, despite the central bank's continuous tightening. The relatively steep rise in credit growth without proportionate increases in deposits have had the effect of tightening liquidity conditions in the last quarter of 2010.

This problem can be attributed to the mis-alignment between deposit and lending rates. The monetary policy changes get transmitted on lending and deposit rate sides at different pace. Banks are relatively quick to respond to lending rate changes, whereas deposit rate changes follow with a greater lag.

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