CD rates to rise on RBI cap on bank investment in MFs

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Interest rates on certificates of deposits (CDs) are likely to rise as demand drops after the Reserve Bank of India's (RBI) directive to banks to cap investments in liquid debt mutual funds, dealers say.

Short-term deposit rates could rise by 10-15 basis points as mutual funds, who are currently the largest investors in CDs, see a drop in assets under management due to less participation from banks, they said.

In the annual policy statement on Tuesday, while lifting key policy rates by 50 basis points each, the RBI said banks' investment in liquid schemes of debt-oriented mutual funds will have a cap of 10% of their net worth as on March 31 of the previous year.

Banks will however get six months to reduce their investments in the liquid funds, the RBI said.

"It can have an effect of around 10 basis points on the 3-month CD rates because mutual funds largely invested in this tenure. Also, this goes with RBI's tightening stance as it wants lending and deposit rates to rise," Manish Wadhawan, director and head of rates at HSBC India, said.

The RBI imposed this cap to stop circular flow of funds into the banking system.

"These amounts do not remain static as if they are always invested at a particular level, in fact every quarter they withdraw for purpose of booking profit and so they used to vary like from 2% to 50%. Now we capped it at 10%, comes to Rs 500 billion," RBI deputy governor Shyamala Gopinath said last week .

Dealers estimate around 600 billion rupees worth of CDs to be unwound in next 6 months from the liquid funds.

"From the current Rs 1.10 trillion, bank's investment in funds could drop to 250-300 billion rupees in the next six months and halve by July," said Maneesh Dangi, head of fixed income investments at Birla Sun Life Asset Management Company.

However, bankers are not overtly worried about adjusting to the new norm as they have six months to comply.

"It will lead to some increase in CD rates. But I don't expect a sharp rise in CD rates as typically the spread between term deposit rates and CD rates have not varied too much in the last one year," said R.V.S. Sridhar, president and head of treasury markets at Axis Bank .

"Banks may trade CDs among themselves and there may not be an arbitrage between borrowing from the repo window and deploying it for a higher return from mutual funds," said a senior trader with a large state-run bank.

The only difference now will be that banks will start investing in each others' CDs, dealers said.

Balance sheet expansion

However, banks will now hesitate to issue large amount of CDs as is usually seen at the end of fiscal quarters to shore up deposit growth numbers in the absence of the large investor base.

Typically CD rates mount during quarter-ends as banks turn aggressive in issuing CDs to show a bigger deposit base.

"Banks which were issuing CDs to show their topline growth may not do so this time, which may reduce issuances. But if liquidity tightens sharply then the 3-month rate can rise to 9.50% in June-end," said a dealer at a large state-run bank.

Yield on the three-month Reuters CD benchmark fell to 9.15% from 9.20% on Thursday, while the 1-year also fell 5 basis points to 9.95%, according to Thomson Reuters data.

"Banks will now have to search for alternative source of raising resources like term deposits. To my mind there should not be any large impact to banks' deposit mobilisation," said Axis Bank's Sridhar.

The RBI projects loan growth of 19% and deposit growth of 17% in 2011/12.

Even if banks prefer to raise funds through retail term deposits, it is easier to raise bulk deposits given the stiff competition to expand customer base.

"It is a question of what happens first. If credit growth picks up, then they will need to raise CDs and so CD rates will rise. Otherwise, banks do not need to be too aggressive in raising CDs at high rates," said a bank treasurer.