Picture this: A business owner in India is about to expand his business by purchasing new equipment and hiring more staff. But here’s the catch – he needs a loan to make it happen.
That’s where the banks and the Reserve Bank of India (RBI) enters the picture.
As the gatekeeper of the country's monetary policy decisions, the RBI holds immense power to influence the cost and availability of loans which in turn impact the decisions of business owners.
Let’s have a look at the key things happening with the RBI's monetary policy, why interest rates are so important and explore how changes in interest rates and monetary policy can impact the banking sector in India.
Here we go…
The RBI's monetary policy regulates the money supply, availability of credit, and interest rates in India. And this further affects the interest rates for bank loans.
Now this is important because banks form the backbone of any economy, as they are responsible for matching borrowers and savers, and enable credit growth and are the focal point of the economy. Click Here to know how you can invest in India’s largest banks.
Here are some of the RBI’s key monetary policy tools:
The repo rate is the rate at which banks can borrow money from the RBI for short-term periods.
For example, let's say that the RBI decides to increase the repo rate. This means that banks will have to pay more interest to borrow money from the RBI. As a result, the banks may also increase the interest rates they charge their customers for loans, including you. So, this would mean higher interest cost and less borrowed money in the system.
But the impact of the repo rate doesn't stop there. Higher interest rates can also lead to a decrease in spending, as consumers and businesses are less likely to take out loans or make big purchases. This can, in turn, lead to a decrease in demand for goods and services, which can result in lower inflation.
Check out this short video to know more on Repo Rate:
The CRR is the percentage of a bank's deposits that it is required to keep with the RBI. By changing the CRR, the RBI can control the amount of money banks have available to lend, which in turn affects the money supply and interest rates.
The SLR is the percentage of a bank's deposits that it is required to keep in the form of government securities. Like the CRR, the SLR affects the amount of money banks have available to lend.
So far, so good. Let us now have a look at why interest rates are important.
Interest rates play a critical role in the economy because they affect the cost of borrowing and the rate of return on savings.
Higher interest rates mean higher borrowing costs, which can lead to a slowdown in economic activity. On the other hand, lower interest rates can encourage borrowing and spending, which can stimulate economic growth.
In addition, as we saw earlier, changes in repo interest rates have a direct impact on the cost of borrowing for businesses and consumers.
For example, a higher interest rate on a loan means higher monthly payments and potentially less disposable income. Similarly, higher rates on savings accounts can lead to higher returns for savers.
Interest rate and monetary policy changes can have a huge impact on the banking sector.
Banks rely on the interest rate spread, which is the difference between the interest rate they charge on loans and the interest rate they pay on deposits, to generate revenue.
If interest rates rise, banks may struggle to attract deposits, and borrowers may be less willing to take out loans. And if interest rates fall, banks may find it easier to attract deposits, and borrowers may be more willing to take out loans.
Here’s what has been going on in India in this regard…
To control rising inflation and prop growth in the country, the RBI started hiking key lending rates in May 2022 after maintaining status quo on the rates for 2 years.
It has so far raised the repo rate by 225 basis points until February 2023. And most Indian banks passed on around 200 basis points to the home loan borrowers in February!
But the tables have turned and the central bank, in its April policy meeting kept interest rates unchanged. The repo rate was kept unaltered at 6.5%.
We will have to wait and watch how banks react to this and if it soothes borrower’s nerves.
Meanwhile, here’s what the RBI’s last Financial Stability Report showed about the banking sector in India:
Indian banks are on relatively strong footing despite weak macroeconomic conditions.
Gross non-performing loans or NPLs declined by 90 basis points (bps) to 5% in 1HFY23.
There is a broad-based recovery in loan demand.
Restructured loans remain low for both public and private banks
Other data from the RBI monetary policy also shows some key trends for bank’s housing loan portfolio:
Housing loan interest rates have moved up 150 bps since March 2022. This portfolio has seen the highest transmission among the reported lending segments.
There has been housing loan growth (15%) which is driven by 10% growth in the number of accounts, and the balance 5% by an increase in the average ticket size.
Metropolitan markets, which contribute 60% of housing loans, are holding up well.
There is a gradual increase in ticket sizes, mostly from public banks.
So, the above trends show that India’s banking sector is on a strong footing.
Lastly, monetary policy changes can also affect the markets.
If interest rates rise, the value of existing bonds and fixed income investments sees a decline as new, higher-yielding investments become available.
In addition, changes in interest rates can affect the stock prices of banks and other financial institutions.
Higher interest rates can weigh on stock prices as market participants would anticipate lower profits due to increased borrowing costs. While lower interest rates could lead to higher stock prices as investors anticipate higher profits due to increased borrowing and spending.
If you’re looking to invest in the banking sector, you’re in for a treat.
Banks often form the building blocks of any portfolio. Click here to explore your First Time Favourites Basket.
And to know the Q4 result expectations of banking as well as other financial stocks, tune into our recent webinar below. Our expert research team led by the Head of Research - Shrikant Chouhan, shares the current market undercurrents, the market outlook, and top stocks for the Q4FY23 result season.
All in all, market participants should remember that interest rates are the name of the game.
Warren Buffett famously said, “Interest rates are to asset prices what gravity is to the apple. Where there are low interest rates, there is very low gravitational pull on asset prices.”
Whether the RBI alters the interest rates in the coming policy meetings remains to be seen. So, keep an eye on these key indicators to stay ahead in the market and make informed decisions about your investments.
References: RBI Monetary Policy, Kotak Securities
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