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Interesting prospects for interest rates

Despite all the talk of an interest rate hike, there will be little scope for banks to alter the scenario comprehensively.

FOR MORE than a year now, it has been clear to everyone watching the economy that interest rates, having reached their lowest points, can only go up. Yet the precise timing — the points at which major banks will decide to mark up their lending rates — could not be gauged correctly.

That moment came last week when HDFC's decision to hike its interest rates on home loans made headlines. In September HDFC and a few other major lenders marked up their rates on home loans that they dispense on a fixed rate basis. That move was a precursor to the latest all round hike but as it covered only a small segment of home loans it did not attract the attention it deserved. As if on cue all banks say they are looking at their interest rate structure in its entirety meaning not just their lending rates but their deposit rates too may undergo a revision.

The list includes major banks such as State Bank of India. Some of the major banks in India are known to act in a contrarian manner in fixing their interest rates. In August, when inflation reached a (then) record high, SBI lowered its short-term deposit rates thereby showing an amazing degree of insensitivity to its large number of depositors.

Compelling factors

There were of course any number of economic reasons that would have necessitated a hike in interest rates much earlier. The resurgence in inflation is certainly the most important of them.

With the rise in wholesale price index (WPI) staying well above 7 per cent and peaking recently there was no way the policy makers could ignore the price situation. Especially because the spike in inflation is attributed to factors that are not expected to dissipate any time soon. High commodity prices, an important cause for the rise in the WPI, will continue to be a potent factor.

Oil prices despite their temporary softening to below $50 a barrel level are still way above what anyone had visualised even a year ago. After considering various options, the Government has been forced in the end to increase the retail prices of transport fuels (petrol and diesel) as well as that of one cooking fuel (LPG). As of now kerosene prices have not been changed. The impact of the latest fuel price increases on inflation will be seen only after a lag.

Slow policy response

On that score as well as on a number of other parameters, no one can be optimistic about inflation. More than the periodic announcements of inflation numbers, it is the management of inflation expectations that has become a major cause of worry.

It is in this context that policy responses have been rather slow in coming. The Reserve Bank of India has price stability as one of the goals of monetary policy. Provision of adequate credit to the industrial sector has been another. Balancing these seemingly contradictory objectives, never an easy task, has become especially tough now.

The softer interest rate regime that has been in place till recently has benefited important sections — the Government through lower costs for its borrowing and corporates through cheaper borrowing. Banks could book large treasury incomes as interest rates moved down and everyone seemed to think that the soft interest rate regime would continue forever. Retail loans led by loans to the housing sector have grown at a furious pace.

It is this perception that the `good times' will last forever that has been difficult to shake off. Even though such an attitude defies economic logic, no one apparently wanted to go against something that has become so popular. Of course, all those good times were not for bank depositors and savers who were compelled to invest in fixed rate instruments at low interest rates. Most of them have been earning a negative rate of return.

Moreover, even at a global level, inflation has been rearing its head. There was no way Indian authorities could have avoided taking unpalatable decisions.

The recent monetary policy review did signal a higher interest rate by pushing up the repo rate by 0.25 percentage points. (The repo rate is the rate at which the RBI takes money from banks against securities). The move was meant to tighten liquidity at the short-end. Earlier in September the cash reserve ratio was hiked by 0.5 percentage points. Barring these two measures there has been no overt interest-hike signalling measures adopted by the RBI. But the central bank did raise its inflation target from 5 to 6.5 per cent.

Significantly it warned home loan providers against being reckless. It increased the risk weightage on home loans by 0.25 percentage points.

Now that the banks have decided to go for interest rate hikes, it will be interesting to see how far they will go. There are obvious limits beyond which their lending rates cannot go up. Competition among banks and between banks and other financial entities is one main reason.

Besides, it is not as though risk-aversion (that has inhibited credit growth) has suddenly disappeared. All this means that banks, even if they want to, cannot adequately compensate their depositors. The fact that for many bank depositors there is no alternative investment avenue is another reason why banks will take their depositors for granted.

C. R. L. Narasimhan

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