Liquidity Easing Will Benefit Busy Season Lending; Reflects Confidence in CAD Management - India Ratings

Mumbai, October 8, 2013: India Ratings & Research (Ind-Ra) says that the Reserve Bank of India’s (RBI) measures to ease liquidity will benefit banks as they enter the ‘busy’ credit season. The gradual unwinding of July’s extraordinary liquidity squeeze also reflects RBI’s growing confidence in managing the current account deficit (CAD) in the short-term. CAD is likely to shrink considering policy initiatives on both foreign exchange demand (squeezing gold import) and supply (subsidised swap window till November 2013).
Liquidity easing measures will immediately be mildly positive for banks’ net interest margin (NIM), unless interest cost savings are passed on to borrowers by reducing lending rates to support the government’s drive to boost growth. Interest costs will benefit from over 100bp fall in short-term money market rates since their peak in mid-August 2013. Easing yields in government securities will also generate trading profits; together with wider NIMs, this will help lift the pre-provision profitability of banks during Q3FY14 after falling in Q2FY14.   
Ind-Ra expects the ‘easing liquidity’ policy stance to continue through the rest of this quarter. This is because the rupee is likely to move within a narrow band and inflation may somewhat ease on the back of increased farm produce. This however may not be enough to decide the medium-term outlook for interest rates. The outlook will likely be influenced by the currency outlook in early 2014 and India’s ability to reduce forward rates to more acceptable levels through tight CAD management. The interest rate outlook will also be governed by a more conducive environment for long-term investments to remove supply constraints in the economy. Till then, RBI may remain cautious with the repo rate and decide on a trend in Q4FY14. The ultimate aim would be a positively sloped yield curve that incentivises long-term savings and boosts deposit mobilisation.       
The liquidity squeeze in the previous quarter highlighted the structural weakness of funding mismatches in many banks. The busy credit season could once again test the system with loan growth outstripping deposit growth by a fairly wide margin. This may once again compress NIM during Q4FY14, particularly if banks’ reliance on higher-cost short-term borrowings were to go up. Ind-Ra has pointed out that such mismatches dilute the transmission of monetary policy when rates are being eased. There is therefore a need for greater matching of banks’ asset and liability tenures. As banks may remain the most significant provider of long-term loans in the system, there could be a need for a measured increase in term liability and to ease the short-term refinancing pressures. A small start has been made through the introduction of term repos of 7-day and 14-day tenor that may help reduce dependence on overnight borrowings.           
RBI’s yesterday action reflects the stability of the rupee around 61-62 to the US dollar and increased demand for liquidity as people withdraw cash from the banking system during the festival season. In view of these factors, RBI has reversed some of the measures announced in July and introduced some new measures to boost liquidity in the banking system and reduce the cost of banks’ borrowing. These are (a) a reduction in the marginal standing facility rate by 50bp to 9.0%, (b) providing additional liquidity through term repos of 7-day and 14-day tenor for a notified amount equivalent to 0.25% of net demand and time liabilities of the banking system and (c) infusion of INR99.7bn through open market operations into the system on 7 October 2013.             
(Source: Corporate Communications and Investor Relations, India Ratings & Research -A Fitch Group Company)