RBI extends its pause: What lies ahead for borrowers, depositors and bond markets

As was widely expected, the RBI paused and held its key policy repo rate at 4 per cent on concerns over sticky inflation. With the inflation forecast now revised substantially upward from earlier estimates, the RBI appears to have ruled out further rate cuts this fiscal.

As against the earlier inflation forecast of 5.4-4.5 per cent for the second half of the current fiscal, the RBI now expects inflation to be at a high 6.8 per cent in Q3 and 5.8 per cent in Q4. This more or less closes the window for conventional rate cuts in the current fiscal.

However, contrary to expectations of a review of the excess liquidity situation, the RBI maintained status quo and assured continued liquidity support to the market. This should continue to ease bond market yields (particularly on the short-end) further. Given that bond yields get transmitted to other segments of the market, and to loan rates, borrowing costs should remain sanguine.

However, given the unfavourable risk environment, banks will continue to charge higher lending rates for riskier borrowers as has been evident in the sudden jump in average lending rates of private banks in October.

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Borrowers: Relief despite no rate cut

The cumulative 250 bps repo rate cut since January 2019 (135 bps in 2019 and 115 in 2020 so far), has indeed aided borrowers. Lending rates have fallen substantially over the past two years, along with the reduction in policy repo rate. The RBI mandating banks to link loans to external benchmarks such as repo rate from October last year has helped bring down lending rates at a faster pace. From January to October this year, weighted average lending rates on fresh loans has fallen by about 98 bps (against repo rate reduction of 115 bps). While this is heartening, the recent uptick in lending rates of private banks need a watch.

According to the latest data released by the RBI on banks’ lending rates, the weighted average lending rate on fresh loans for private banks has gone up by 36 bps in October to 9.02 per cent from 8.66 per cent in September. The final lending rate is a function of the benchmark rate and the spread that banks charge over it. Banks decide the spread over the external benchmark, depending on their assessment of the borrowers’ credit risk premium. Given the lingering uncertainty in the business environment and higher credit risk, it is possible that few private banks are charging higher spread on certain loans. This, aside from uptick in lending activity, could be reason for the lending rates to increase in October.

What is evident is that high rated corporates are able to raise funds at a much cheaper cost both from banks and the bond market.

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The RBI’s continued liquidity support and the move to extend the on tap TLTRO facility to more sectors, should help in bringing down borrowing costs further. Hence despite no cuts in repo rate, certain segments of the market should see lending rates come down.

Depositors: Pain could continue

Savers have been hit hard over the past two years, with deposit rates falling sharply. In fact, since March this year, bank fixed deposit rates have fallen by 175-200 basis points across many banks, even higher in some cases. Depositors are already feeling the heat, grappling with negative real returns on their deposits. Currently public sector banks are offering about 4.9-5.25 per cent on 3-5 year deposits. With inflation raging above the 7 per cent mark, further deposit rate cuts (triggered by surplus liquidity and low bond yields) will only pinch depositors more.

However, private banks offer higher rates of 5-7 per cent.

While the RBI is in for a long pause on rate action, deposit rates could continue to fall.

Bond markets: A sigh of relief

The surplus liquidity has led to a steep fall in short-term interest rates. In fact, most of the rates are even below the prevailing reverse repo rate of 3.35 per cent. This distortion in the short-term rates had triggered expectations of a review in the RBI’s liquidity stance.

But the RBI assuring the market of steady and easy access to liquidity, has cheered bond markets.

Foreign inflows have been strong and are likely to continue. The RBI has been buying dollars since April, to manage the rupee appreciation. This has been a major reason for domestic liquidity to increase sharply. But the RBI in its policy said: “while it is mindful of the consequences of these actions for domestic liquidity and inflation, the injections of liquidity through forex interventions are being sterilised by absorptions through the reverse repo”.

This implies that bond yields could continue to remain soft on the back of surplus liquidity. Three-month T-bill can continue to trade below the reverse repo rate of 3.35 per cent.

The 10-year G-Sec yield has been maintained below the 6 per cent mark through RBI’s liquidity measures, operation twists and the recent outright OMOs. However, it is still about 190 bps above the repo rate of 4 per cent, on the back of concerns over the government’s borrowing programme and high inflation. The RBI assuring that it would continue with its OMO purchases (despite leading to higher liquidity) and operation twists, should offer comfort to bond markets in the near-term.