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Indian businesses and consumers may have to live with high borrowing costs until the second half of 2012, even if the Reserve Bank of India (RBI) obliges with an interest rate cut as early as March.
Scores of private and state-owned banks, saddled with high-cost long-term deposits, narrow profit margins and the threat from a rising volume of bad debts, will be hard-pressed to follow the RBI with a cut in lending rates.
Sensing that rates have peaked, consumers and businesses alike have rushed to park money in long-term deposits at banks, burdening them with high costs on their biggest source of funding in the foreseeable future.
It normally takes one quarter or even two for changes in policy rates to trickle down through the $1.8 trillion economy. This time, the stressed banking sector could prolong that process of monetary policy transmission even further.
That is, of course, if the Reserve Bank of India chooses to cut interest rates. So far it has been loath to do so, maintaining that its battle against inflation is a priority even in the face of slowing growth and struggling businesses.
That the economy's biggest lenders will be hit hard by a cut in rates is an added incentive for the central bank to go slow.
The RBI has raised rates 13 times since March 2010 in a tightening cycle that is widely seen to have ended, as a drop in headline inflation rates has raised expectations of a rate cut in March or April.
India's benchmark policy rate, at 8.5 percent, is at its highest since July 2008.
"Cost of funds have to come down first," said Saday Sinha, deputy vice president of research at Mumbai-based brokerage Kotak Securities. "Only then banks will cut lending rates, otherwise margins will suffer."
The minimum lending rate for the country's top lender State Bank of India has risen to 10 percent compared with 8 percent last January.
Cost of funds for Indian banks, which is around 7 percent now, is expected to remain high over the next 12 to 18 months, adding pressure to keep rates high, analysts said.
Average net interest margins have dropped below 3 percent from about 3.5 percent in the financial year ended March 2011, analysts say.
Bank loans have expanded a tenth so far in the financial year that began in March, slower than the pace at which retail and wholesale investors have pushed cash into double-digit-yielding deposits with banks. Those deposits amount to about $1 trillion, nearly 90 percent of banks' liabilities.
Cash has also moved rapidly from the low-yielding savings accounts at banks into the more expensive term deposits, borne out by the nearly 15 percent climb in money supply on year and a much slower pace of growth in base money.
Banks' ability to lower rates is further impeded by the fact that they have lent heavily.
On average, new lending for these banks is about 74 percent of their fresh deposits, better than about 100 percent last year, but when one accounts for compulsory reserves to be maintained at the RBI, this means banks have stretched their balance sheets to a large extent.
N.S. Venkatesh, head of treasury at state-run IDBI Bank, expects margins for the system to remain under pressure at least until September.
Kotak's Sinha expects high costs to squeeze banks' margins by up to 20 basis points in the financial year starting April.
As a result, income from interest is likely to drop, hurting banks' earnings, analysts said.
"The added twist to it now is the NRE deposits," said Sanjay Mathur, economist at Royal Bank of Scotland in Singapore.
Deposits from non-resident Indian accounts, or NRE, which are also earning interest of more than 9 percent have risen since December after the RBI freed the deposit rates in an attempt to support the weakening rupee.
NRE deposits are estimated to have risen five or six times to about $3 billion in the last two months.
"We will not be too willing to touch lending rates if RBI cuts only 25 basis points," said chief financial officer of a state-run bank who did not want to be identified. "It has to be at least 50."
Another problem plaguing banks is the tight liquidity in the system, forcing them to borrow at higher rates for their daily requirements.
"There is still requirement for liquidity in the system. So, everybody is forced to borrow at high rates," said Sudhir Kumar Jain, general manager of treasury at state-run Dena Bank, adding that banks are raising money through certificates of deposits (CD) at about 9.95-10 percent for three months to a year.
The RBI has signalled that inflation rates have peaked and has been increasing liquidity by cutting banks' reserve requirements and through open market operations and bankers expect it to continue to infuse cash.
Banks have also been struggling to grow their loan books to boost profits, which may put pressure to lower lending rates.
Loan growth for the industry is expected to slip to 16 percent in the fiscal year that ends in March compared with more than 20 percent a year earlier.
"If some bank goes ahead and reduces the rates then others will follow. We can't let go of a good customer," IDBI's Venkatesh said.
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