Retail borrowers, who were probably looking forward to the monthly instalments on their home and auto loans falling, may have to now brace themselves for just the opposite.

The Reserve Bank of India’s measures on Monday to curb rupee volatility are likely to reduce liquidity, trigger a spike in short-term borrowing rates and prompt banks to defer lending-rate cuts for now .

These measures will clearly increase cost of borrowings for banks, which may even lead to higher interest rates in the short term.

To explain why, we need to understand the measures taken by the apex bank.

First, the central bank has capped the amount banks can borrow from overnight markets to Rs 75,000 crore. This is essentially the borrowings they make through the liquidity adjustment facility (LAF).

Second, the RBI has increased banks’ cost of borrowing short-term money through the marginal standing facility (MSF) by 200 basis points to 10.25 per cent.

Currently, banks can borrow funds overnight through the MSF at 8.25 per cent if they exhaust their regular limits on LAF.

Thus, short-term borrowing rates will immediately go up for banks that are highly dependent on certificate of deposits (CDs) and wholesale deposits.

YES Bank and Kotak Mahindra Bank, for instance, have higher dependence on such deposits. As the cost of funds go up, these banks are unlikely to cut lending rates in the near term.

Does liquidity matter?

But what about the rest of the banking system? Given that loan growth has slowed to 13.7 per cent, does lower liquidity matter?

Currently, deposit growth, at 13.8 per cent, is marginally above loan growth. As incremental opportunities for lending have shrunk, liquidity may not seem to be an issue right now.

However, the third measure in the set of steps taken to mop up excess liquidity may just tip the balance against them.

Consider this. Banks were borrowing about Rs 97,000 crore from the LAF window even during May.

It is only in June and July that this has moderated to Rs 65,000 crore and Rs 46,000 crore, respectively.

But the RBI did supplement this by infusing liquidity by purchasing gilts to the tune of Rs 22,000 crore until June.

Now, the RBI plans to do just the opposite. It has announced the sale of government securities to the tune of Rs 12,000 crore on July 18 on top of the Rs 15,000-crore sale already announced.

Thus, as liquidity gets scarce once again, there may be a scramble for funds and banks will find it difficult to cut lending rates.

Assuming banks need to borrow Rs 1-lakh crore per day, their overall cost of funds will go up by 75 basis points.

Thus, to maintain their margins, banks say they may actually end up raising their base rates, to which all lending rates are benchmarked.

In 2012-13, banks also made a killing on falling government security yields as interest rates declined.

With 10-year gilt yields now spiking by 50 basis points after the announcement of these measures, gilt prices have taken a hit. Expect treasury gains to take a hit in the September quarter.

radhika.merwin@thehindu.co.in

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