Excess PSU and state paper pushing bond rates up
With the fiscal deficit having been reined in at 3.5% of GDP, the government is hoping its planned fiscal prudence will prompt RBI to lower the repo rate. A lower wholesale borrowing rate, it hopes, will in turn spur banks into cutting rates for their customers. However, given that loans are funded primarily by retail deposits which have been growing at a subdued pace of just 10-11% over the past year, it is the cost of these liabilities that banks are more concerned about. To be sure, the cost of deposits has been trending down—SBI now pays just 7.5% for one-year money while private sector banks pay a little more. But small savers have many more attractive options—the PPF offers 8.7% and interest earnings are not even taxed, unlike those in banks, while the Sukanya Samriddhi scheme offers a tax-free 9.25%. Even after rates have been cut for some small savings schemes, the average rate for 65% of the schemes where no cuts are planned is around 8.8%, much higher than what banks can offer. To be sure, small savings are much smaller as a proportion of bank deposits—less than 10% today compared to 26% a decade ago—but banks have good reason to be worried and cannot afford to drop rates beyond a point. In which case, it is finance minister Jaitley who also holds the keys to rate cuts, not just RBI Governor Raghuram Rajan.
The competition from small savings, however, is just one reason why monetary transmission has been slow, even though it is true that the Liquidity Coverage Ratio requires banks to have high retail deposits, thereby increasing competition. The other big reason is that banks need to make large provisions for loan losses—and these are rising fast, thanks to new recognition norms. Banks, therefore, are simply not willing to compromise on their margins. Besides, rates remain elevated not merely for banks, but also in the bond market. Apart from the fact that the yield on the benchmark was nudging 8% not so long ago, coupons on the recent state government loans have also been high, with West Bengal paying 8.8%. The increase in the supply of loans in the market has given buyers more bargaining power and yields have moved up. With a clutch of government entities expected to borrow an additional Rs 60,000 crore to fund their capex for FY17, it is unlikely rates are going to head down in the near-term. While the UDAY bonds may be privately placed and the issues not floated, they would nonetheless soak up some liquidity if bought by entities like the EPFO and Life Insurance Corporation. Of course, that would free up some resources for banks. Foreign portfolio investors could be big buyers of bonds in FY17—to the extent permitted—given the returns are attractive, though the cost of hedging the investment will take away some of the gains. In their absence, however, the cost of money could remain high, especially if state governments decide they are going on another borrowing spree like they did this year, picking up a record R70,000 crore extra.