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Interest rates: Staging an encore! - Views on News from Equitymaster
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  • Dec 27, 2006

    Interest rates: Staging an encore!

    With the Reserve Bank of India (RBI) initiated CRR revision of 25 basis points being effective this fortnight, the short term call money rates have spiraled to 11.5%, moving up by 200 basis points in a week's time. This makes short-term money available at a premium of nearly 400 basis points above the 10-year G-Sec yield of 7.6%. Also, the wholesale price index (WPI), the yardstick for inflation, has moved up to 5.3%, edging close to the RBI's tolerance limit of 4.5% to 5.5%.

    Tightening liquidity and rising inflation, along with the firmness in GDP growth, are precursors of an economic overheating that must be curbed by the central bank using the monetary tools at its disposal. The RBI has dutifully done so over the past couple of months using the repo and reverse repo rates and finally triggered the tightening with a hike in the non-remunerative (non interest yielding) CRR.

    Interest rates dropped from a high of 17% to 18% in the late 1990's and early years of this decade to single digit lows of 6% to 7% by 2003. Thereafter, the rise in global cost of capital made it pertinent for the domestic interest rates to sustain their attractiveness in a bid to lock in foreign funds. Banks, therefore, had to consistently keep raising their deposit rates to attract funds for lending, thereby squeezing their net interest margins. Although with a lagged effect, the passing on of rate hikes to customers soon followed, thus bring the benchmark PLR (prime lending rate) to double-digit figures once again.

    Home loans under the hammer
    The benchmark PLR had lost its significance in the falling interest rate regime with banks offering loans to their AAA-rated customers (having the best credit worthiness) at a significant discount to the same to keep up with the competition. Home loans, which were the prime driver for banks' exposure in the retail category and having a priority sector classification, also enjoyed rates as low as 7%. Besides, banks were comfortable with a loan to value ratio of 90% given the rising repayment power of borrowers.

    The rise in interest rates, however, retarded the incessant growth of this segment. This started with the RBI adopting a cautious stance on the provisioning for home loans given the higher instances of delinquency in a speculative mortgage market. With the country's biggest home loan disbursers namely ICICI Bank, HDFC Bank and SBI having raised their PLRs to as high as 13.5% (HDFC Bank) and 11.5% (SBI), the possibility of the 25% YoY growth in mortgage loans sustaining seems to be a bleak possibility.

    We believe that while the rise in interest rates will be very gradual and not suicidal enough to trigger a recession, the economic buoyancy will certainly see a moderation in the coming quarters with the central bank living up to its commitment towards capping the inflationary pressures and thwarting the negative repercussions of the same.



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