Interest rate means various things to various people. To a business person, it means the rate at which she takes a loan from the bank. To a retiree, it means the rate at which she places a deposit with the bank. To a market expert, like a fund manager or a bank treasury manager, it means the yield level on government or other bonds. To a policymaker at the Reserve Bank of India (RBI), it means the signal given out in the form of overnight repo rate. The impact of movement of interest rates in the economy depends on which side you are: if you are a borrower, the lower the better, and if you are a saver, the higher the better. From an overall perspective, lower interest rates are better because they induce borrowers to take more loans. If an industrialist is taking loans, she is creating capacities, which will expand the gross domestic product (GDP) of the country. If an individual is taking a housing loan, it’s about building houses i.e. creating demand. If interest rates are high, it may induce people to save, but the savings need to be put to productive use.
Staring at the coming financial year, we are at a juncture of opposing forces on movement of interest rates. To understand how interest rates are supposed to move in the economy, the pivot takes cue from RBI’s overnight repo rate. That is, RBI signals interest rate movements in the economy by increasing or decreasing the repo rate, which is currently at 6.25%. Recently, RBI reduced the signal rate from 6.5% to 6.25% on 7 February 2019. Inflation in the economy being low, 2.57% on last count, it provides room for easing the policy rate. It is expected that in 2019-20, RBI will continue easing rates. The reason is that the “real” rate of interest i.e. interest rate available on savings minus inflation is on the higher side. This is good for savers, but it has to be fair to borrowers as well, due to the reason discussed above. As a growing economy, we need capacity creation.
Normally, one would expect that if RBI is reducing interest rates, the interest rate structure in the entire economy would follow suit. Earlier, RBI did not care much about transmission of interest rates to the economy. Since 2016, banks have been mandated to price loans as per marginal cost of funds-based lending rates (MCLR), which leads to better transmission of RBI’s rate signal. However, there is a twist in 2019-20. There is higher demand for funds from multiple segments—central government security issuances, state government security issuances and corporate bond issuances—all higher than 2018-19. On a ballpark estimate, net government security issuances (i.e. net of maturities) is higher by 12% in 2019-20 over 2018-19, net state government security issuances is higher by 7.5% in 2019-20 and corporate bond issuances are expected to be higher by 22%.
Corporate bond issuances are expected to be higher, also because of Securities and Exchange Board of India’s (Sebi) rule that comes into effect from 1 April 2019 that large corporates will have to borrow 25% of their requirements through bond issuances rather than bank loans, to deepen the corporate bond market. Moreover, credit off-take from the banking system is growing at a buoyant pace. As per the latest count, credit off-take is increasing at 14.6%, much higher than the deposit growth rate of 9.8%. In 2019-20 also it is expected that credit will increase at a fast pace as the after-effects of demonetisation and implementation of goods and services tax (GST) are over and things have settled down. The import of all this is that there is a higher demand for funds this year over the previous year. As we all know, if the demand for funds is higher, the cost of the commodity, which is interest rate, is expected to go up.
What makes things more interesting are that (a) RBI says lending rates will be taken one level ahead of MCLR, which is ultimately controlled by the bank, to an external benchmark like RBI repo rate or treasury bill yield. As and when this is implemented, bank lending rates will move up or down much faster, as per changes induced by RBI. As discussed, RBI is expected to reduce interest rates in 2019-20, hence lending rates are expected to ease and (b) State Bank of India (SBI) has linked part of the savings and deposits with the RBI repo rate, hence deposit rates, at least partially, will move with RBI’s signal. SBI being the big daddy, other banks are expected to follow suit.
That brings us to the final question: with demand for funds being higher in 2019-20, as and when RBI reduces the signal repo rate, how much will be transmitted to the real economy? RBI is serious about implementation, which makes for a story to unfold over the coming months.