Banks may not pass on rate hikes, yet

The RBI Governor took back some of the Christmas cheer by increasing the policy repo rates on Tuesday.

This will increase banks’ cost of funds, at a time when good lending opportunities are hard to come by and bad loan problems are aplenty. But borrowers may not feel the pinch yet. Deposit and lending rates may not move up immediately, as the liquidity scenario has eased over the last two months.

The repo rate, the rate at which banks borrow from the RBI under the liquidity adjustment facility (LAF) window, has been increased from 7.75 per cent to 8 per cent.

The impact of this is three-fold. One, banks borrow close to Rs 38,000 crore daily under the LAF window. Thus the increase in repo rate directly impacts the cost of borrowings through this window. Two, banks also borrow through Marginal Standing Facility (MSF), over and above the LAF. The cost of borrowing here is 100 basis points higher than the LAF repo rate, and hence the MSF rate which is now at 8.75 per cent will move to 9 per cent. Three, the new term repos which are available to banks at 8 per cent currently, will also see rates go up by 20-25 basis points.

Overall, average cost of funds for banks will increase by about 20 basis points as banks borrow more than 80 per cent of their requirement through LAF and term repo windows.

But users of banking services can breathe easy as lending or deposit rates may not go up significantly. Lending rates are a function of deposit rates, and hence unless there is a significant increase in the latter, the former will not change. For now, deposit rates may not go up in a hurry.

The transmission of any monetary policy — up or down — is dependent on the prevailing liquidity conditions. Since September, the 100 basis points cost savings by banks did not flow through to borrowers, due to a tight liquidity scenario.

Now, by the same logic, a more comfortable liquidity scenario will mean that repo rates hike may not be passed through immediately.

The liquidity position for banks has significantly improved ever since the RBI opened up term repo windows and made FCNR (B) deposits more attractive.

“The immediate impact of rate increase will be on money market instruments, which now track the yield on term repos, says Jaideep Iyer, Deputy CFO & Group President, Financial Management, YES Bank.

The RBI in its monetary policy does seem to indicate that further policy tightening in is not anticipated for now. “The good thing is that there is more certainty in the direction of the policy action. This may be the last of the rate hikes for now” says Jaideep Iyer.

But Tuesday’s monetary policy action is a clear indication of the central bank’s emphasis on adopting a path of disinflation and targeting CPI inflation as proposed by the Urjit Patel committee.

“There still remains considerable uncertainty about whether CPI inflation rates could moderate to below 8 per cent by January 2015. The inability to meet the target could prompt the RBI to hike rates further. Besides, the prospect of a gradual reversal in US monetary policy could force emerging market central banks, like the RBI, to tighten monetary policy to defend their respective currencies, says Abheek Barua, Chief Economist, HDFC Bank.