Friday, February 27, 2009

Why lending rates are not coming down?

The reluctance of banks to lower retail and commercial lending rates despite the steep rate cuts by the RBI remains a big concern for the Government. There are a number of reasons adduced for this reluctance - high cost of capital, global financial market turmoil induced counter-party risk perceptions etc. Here are a few other reasons.

The graphic below, which captures the yield movements of the ten year government securities, 91 day T-Bills, and Commercial Paper (the upper bounds of the rate ranges) issued by corporate India to finance its regular operations, reveal a few things about this reluctance. As can be seen, not only have both the rates been increasing, the spread too has been widening alarmingly.

1. The yields on 10 year G-secs, an indicator of the medium term inflation prospects, have been hovering in the 7-8% range. Conventionally, this should be in the range between the repo (5.5%) and reverse repo (4%) rates. This indicates that the markets have priced in higher inflationary expectations, which does not portend well for the longer term interest rates.

2. The CP rates have been going up continuously since April 2008, a fair representation of the credit risk perception inherent in the market. However, in keeping with the flight to short term T-Bills and the declining short-term inflationary trends, the yields on the 91 day T-Bills have been showing downard trend. Most ominously, the spread between the 10 year G-Secs and CP have been widening sharply, and is well past an alarming 10%, reaching 11% plus by end of January. Without this spread closing gap, there is limited possibility of the credit squeeze easing and banks opening their lending taps to normalcy.

Thanks to Amol Agarwal for pointing out the mistake about the G-sec yields hardening being an indication of inflation. Actually, it ought to have been "G-Secs have hardened in anticipation of higher interest rates in future".

He also makes two other important points
1. The declining yields enabled many banks to profit substantially. But with yields hardening since January, the profit cushion dispappears, and may make banks even less willing to lend.
2. CP yields have risen due not only to credit risk, but liquidity risk, as the lower trading in these instruments has incrased the liquidity premium.

No comments: