A rate cut by RBI will squeeze profitability of banks

It took the intervention of the RBI to moderate growth in these segments.

With monetary policy being a perennial tossup between growth and inflation, current data has not been good on both counts queering the pitch for the RBI. While Q1 real growth slowed down the October CPI inflation shot up to 6.21 percent, the highest in 14 months.

Earlier, the Monetary Policy Committee (MPC) in October had voted to keep rates unchanged believing that both the growth drivers, namely, private consumption and investment were “resilient” giving headroom to the RBI to focus on inflation. But with inflation showing no signs of abating, growth supporters have become restless and the din on interest rate reduction has become louder. Both the commerce minister and the finance minister have suggested that RBI should bring down policy rates even if food prices- driven inflation was running high. The targeting of food prices through interest rates, it was argued, is a flawed theory while the FM was more explicit in calling the current cost of borrowing as “stressful” and inhibiting credit offtake by industry.

Credit growth puzzle

There is no arguing the fact that lower cost of credit spurs consumption and investment, both drivers of GDP. But data seems to be at odds which leaves some open questions for policy making. If higher cost of credit inhibits credit offtake, how should we explain the uptick in credit growth of 15 percent in 2022-23 and 20 percent in 2023-24, post the RBI’s policy rate hike of 250 basis points?

One explanation was that the transmission was delayed and also partial (banks raised their lending rates by only 174 bps) but the spike in growth under personal loans (24 percent) and lending to NBFCs (22 percent) is still sizeable. This suggests that credit was impervious to cost which appears counterintuitive, especially if credit had gone to finance consumption, not investment as believed. The growth came mainly in home loans (25 percent) and from unsecured loans, gold loans and credit card debt, which together grew at an average 24 percent in the two years.

It took the intervention of the RBI to moderate growth in these segments.

As to the impact of credit on consumption, the composition of consumption expenditure, 40 percent on essentials (food and other non-durables) and 50 percent on services (largely transportation, housing and miscellaneous services), and the constituents of personal credit – nearly half is under long-term home loans- suggest that the linkages are not so straightforward. In fact, the impact of home loans on GDP growth is through gross capital formation than consumption, as can be seen from gross capital formation data.  To be sure, the rest of the of banks’ personal credit could be said to be consumption-oriented, but the point is that rate hikes did not deter consumption credit, which grew by 27 percent and 19 percent in the two years post the rate hikes.

It has also been argued that credit grew precisely to counter the effects of inflation on consumption. This is plausible since spending on essentials and services such as transportation, health etc. is sensitive to inflation. But the drop to 4 percent in consumption growth in 2023-24 after growing at an average 9 percent earlier years, is more likely the effect of inflation and falling incomes.

If rate hikes did not deter consumption credit, will a rate cut spur more growth? Possibly yes but for the RBI’s discomfort which seems to be keeping this segment on a leash for now.

Criticality of credit-output linkage

Though bank credit’s linkages with growth work both though the demand and output sides, it is the latter which is crucial because of its impact on job creation and income growth. The imponderable here has been industry and manufacturing in particular. This sector was expected to borrow, undertake capex to expand capacities and create more jobs in the economy. Unfortunately, industry was a laggard averaging a growth of only 6 percent in the past three years even as agriculture (15 percent) services (17 percent) and personal loans (21 percent) grew rapidly.

Though some segments such as MSMEs did absorb credit that was more on the back of government guarantees. Long term industrial finance is sensitive to cost of credit, but the problem on hand is inadequate demand coupled with excess capacities, not so much credit. More importantly the capacity issue with banks also weighs on them.

Banks are more risk averse now

Banks are more risk averse now with their prior experience in infrastructure and project lending and their asset liability profiles continue to be unfavourable for long term financing. Not surprisingly then, over half of the bank credit to industry is made up of working capital and medium-term loans. It is unlikely therefore that a rate reduction would significantly alter the scenario.

Government also benefits from low interest rates given its large debt. But the larger issue with government debt is the so called crowding out effect.  Bank deposits (46 percent), insurance and pension funds (25 percent) together form 71 percent of household savings, of which nearly 27 percent of bank deposits and 40 percent of insurance and pension funds are pre-empted by government to finance the fiscal deficit. This has been one of the major causes for the absence of a well-developed debt market that would not only have taken the burden off banks, but also aided better rate transmission in the financial system.

There is also the question of whether banks have the headroom to reduce lending rates.  When their incremental lending rates went up by 174 points between March 2022 and Sept 2024, their incremental rupee deposit rates shot up by 242 points. Despite deposits continuing to be under pressure, they managed to remain profitable. Though a rate cut looks unlikely now, if and when it happens it may perhaps be their turn to experience stressful borrowing costs.