Wednesday, December 15, 2010

The Yin and Yang of interest rates

The Indian government has managed the inflation numbers, if not inflation. This should make it somewhat easier for the RBI to take a pause in interest rate hikes. Markets are keenly watching for signals from our central bank as it goes public with its credit policy today. Out in the daily business of buying and selling bonds, RBI has been busy providing support to bond prices, by buying them up, and keeping bond yields down - the benchmark 10-year yield is being capped at 8.1%. This is the yin, or the soft, approach to banking.

From the point of view of banks, though, there is another dynamic they have to deal with, which is the depositor. Businesses are clealy hugry for cash, and credit is growing at 23% per annum. However, depositors are signalling that bank deposits are not attractive at current rates, and the deposit growth in banks is trending at less than 15%. This is a huge gap, and it cannot be made up by equity capital alone - banks will have to raise deposit rates; and then, to retain their margins, they will have to raise loan rates. This the hard, yang reality of banking in a nation where inflation is running high.

Irrespective of whether, and when, RBI raises rates, India will have to move up the interest rate curve as long as inflation is not contained. A pause in interest rate hikes by the RBi may take some pressure off banking stocks, but this should be seen as an opportunity to exit the sector before a new slide sets in.

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