The Reserve Bank of India recently announced a one per cent cut in the bank rate from 8% to 7% and an equal reduction in the cash reserve ratio (CRR). The bank rate is the rate at which RBI lends to the commercial banks. The cash reserve ratio is the minimum amount to be held in cash with the RBI by the commercial banks. This amount is invested in government gilt edged securities such as treasury bonds which fetch returns in the range of 4.5 to 5% per annum
In line with the recent decision, IDBI, IFCI and the SBI have brought down the prime lending rate (PLR) by from 12% to 11%. Most of the other private sector banks such as HDFC Bank, ICICI Bank and Centurion Bank intend taking a decision shortly.
The immediate fall out of the reduction in the cash reserve ratio is the infusion of Rs 7 bn into the banking system which will substantially improve the liquidity position. These funds which were fetching 4.5% returns per annum will now fetch returns of 11% to 12%. This will improve the profitability of the banks.
Another reason which will improve the profitability of banks is the reduction in interest on savings bank deposits by half a per cent from four and a half per cent to four per cent.
This follows on the heels of a decision of banks to bring down interest rates on fixed deposits placed with them by one to one and a half per cent.
Yet another reason for the improved liquidity of banks is the sharp increase in the quantum of fixed deposits tapped by banks following the volatility in the stock markets.
This is in addition to the overall increase in fixed deposits with banks on account of an increase in the savings rate.
Hitherto mutual funds were much the preferred form of investments over fixed deposits, in view of the increasing returns offered by the former as opposed to the declining returns offered by fixed deposits. There has been a return to fixed deposits as a preferred form of investments.
The immediate beneficiaries of the reduction in lending rates by banks are the bricks and mortar companies who require a lot of funds for their working capital and expansion plans. There has also been an increase of quality companies in the fields of technology related areas. These companies have reported quantum jumps in earnings over the last few years and are considerably less risk prone.
Private sector banks who have significantly lower non performing assets as opposed to public sector banks and are not bogged down by priority sector lending norms, unlike public sector banks are better positioned to take advantage of the cut in the prime lending rates. It is also bound to bring about a shift in borrowing patterns. Owing to high domestic borrowing costs, more and more borrowers were tapping the foreign markets where interest rates are around 8%. In addition they have to incur expenditure on hedging and incidental expenses. Thus with the reduction in the spread in domestic and foreign costs, more and more companies will be tempted to resort to borrow domestically.
Overall the rate cuts are bound to give a fillip to industrial growth and augurs well for the economy as a whole as the Gross Domestic Product (GDP) is likely to go up to 7 % from 5%.