The RBI governor Raghuram Rajan’s move to cut the key policy rate by 25 basis points on Wednesday, cheered markets and propelled the benchmark index-- Sensex above the 30,000 mark; something that the Finance Minister failed to accomplish in his most awaited Union Budget last week. This is the second rate cut since the beginning of the calendar year. With a clear scope of another 25-50 basis point rate cut over the next couple of months, borrowers can finally look forward to lending rates cooling off towards the end of the year.
Budget cues
While the Budget failed to cheer markets, it has given the necessary impetus for monetary easing. Aside from the RBI’s growing comfort with falling inflation, the Centre’s commitment to walk the tight fiscal path, has also given the RBI the headroom to ease policy rates. Various reforms announced in the Budget, particularly for reviving infrastructure has also nudged the RBI to lower rates as a pre-emptive measure to improve credit offtake.
The last rate cut announced in January was also outside the policy review cycle and took markets by surprise. But since then only a handful of banks cut their base rates—to which all lending rates are benchmarked. Large banks such as SBI, ICICI Bank and HDFC bank are yet to revise their base rates.
Lending rates to come off
Banks have been dragging their feet despite having reduced their deposit rates over the last couple of months. But that may change soon.
One, given the RBI’s real risk-free rate target of 1.5-2 per cent, there is still scope for further rate cuts through the year. If CPI inflation remains at sub 6 per cent, and trends towards 5 per cent by end of 2015-16, the RBI is likely to lower its repo rate (now at 7.5 per cent) to 7 per cent by the end of this year.
Two, banks have already seen their cost of funds decline over the past year and may now be forced to pass on some of the benefit to borrowers.
Banks have also been reluctant to cut rates, as the high risk in the system has demanded a higher spread on loans. If the economy recovers as expected, then the risk in the system should recede, giving banks enough headroom to lower rates.
However, since each bank decides its base rates, based on cost of funds, administrative costs and profitability, the rate action will vary from one bank to another.
Also, in case of public sector banks, given the poor performance in the latest December quarter, lending rate cut will only stress margins even more. With stressed assets at over 10 per cent of loans, these banks are already earning lesser income on assets. Hence, the decision to lower rates will vary across banks.
Good news for bonds
The bond market has already rallied over the last one year. The yields on 10-year G-Sec, has been trading below the RBI’s key policy rate since the December policy review. While the downward rate cycle is good news for bond markets, the pace of rally may slowdown from hereon. The yields are now at 7.67 per cent, marginally above the policy rate (7.5 per cent). Given that the chunk of the rate cut--50 basis point—has happened in the beginning of the year, the market is likely to temper its expectations going ahead.