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Banks’ Pass Through of Rate Hikes Fastest of Past Three Cycles: RBI

Analysis of Faster Bank Rate Transmission in India

Source: The analysis is based on information from an Economic Times (ET) article published on January 3, 2024.

Analysis for a Layman

The Reserve Bank of India (RBI) has observed that Indian banks are now passing on increased interest rates to customers at a much faster pace compared to previous rate hike cycles. This phenomenon, known as “monetary policy transmission,” involves banks adjusting interest rates on loans and deposits in response to changes in the central bank’s key repo lending rate.

In the current cycle starting mid-2022, banks have increased lending rates by 112 basis points (bps), which accounts for 45% of the total 250 bps rate hikes by the RBI. This level of transmission is significantly higher than in 2013-14 and 2018-19 when repo rates were also increased. The RBI attributes this improvement to new rules requiring banks to link loan rates to external benchmarks, such as the repo rate.

On the deposits side, banks have also raised interest rates paid to customers by 172 bps, which is faster than in previous cycles. This allows banks to partially offset higher funding costs incurred due to RBI rate hikes. The RBI anticipates that this faster transmission trend will persist, meaning that banks will continue adjusting loan and deposit rates more quickly as policy rates change.

For borrowers, this implies that loan EMIs could continue to rise rapidly with future rate hikes. On the positive side, depositors stand to gain from higher returns on savings accounts and fixed deposits. The RBI expresses satisfaction that its tightening policy actions are effectively influencing interest rates at the bank level through faster transmission mechanisms.

Banks’ Pass Through of Rate Hikes Fastest of Past Three Cycles: RBI

Impact on Retail Investors

For regular retail equity investors, this news has limited direct impact as their market exposure is mainly to non-banking companies. However, tactical investors should consider second-order effects on industries sensitive to interest rates, such as Housing Finance, Auto/CV Loans, and Consumer Goods. Companies like HDFC, LIC Housing Finance, Bajaj Finance, as well as auto manufacturers, may experience pressure if rate hikes persist.

Banks, especially top private lenders like ICICI Bank and HDFC Bank, could benefit from faster loan repricing to protect Net Interest Margins (NIMs). The improved deposit rate transmission ensures stability of deposit funding, mitigating asset quality risks. Investors should assess the specific operating trends of individual banks.

Higher returns on fixed deposits may make bank FDs more attractive for retail investors, potentially drawing in more deposit inflows for both private and public sector banks.

In summary, while mainstream equity investors may not be directly impacted, those targeting rate-sensitive sectors or specific banking/NBFC companies need to consider the nuances of business models and interest rate risk strategies.

Impact on Industries

Industries Most Directly Impacted:

  • Housing: Higher home loan rates could dampen real estate demand, affecting developers like Oberoi Realty and Prestige.
  • Auto: Interest-sensitive sectors, particularly passenger vehicles and commercial vehicles, may see a decline as vehicle loans become costlier, impacting companies like Maruti and M&M.
  • Consumer Discretionary: Products involving larger credit purchases, like durables, may experience deferred demand with higher lending rates, affecting firms like Voltas and Whirlpool.

Industries That Could Benefit:

  • Banks: Faster loan repricing protects net interest margins and boosts savings deposit inflows for both private and public sector banks.
  • Deposit Platforms: As bank deposit rates become more attractive, fixed-income-focused fintechs and wealth management firms may see increased retail participation.

Directionally, rate-sensitive sectors might be impacted by transmission effects, while banks and fixed-income channels could see offsetting gains from the same trend.

Long Term Benefits & Negatives

Positives:

  • Financial Stability: The policy transmission mechanism works appropriately by linking bank lending rates better to market costs, avoiding scenarios where rising market rates choke bank profits.
  • Deposit Growth: Higher savings deposit rates over the long term could deepen financial savings, providing stable low-cost funding for sustainable lending growth.
  • Macroeconomic Control: Rapid pass-through of RBI rate signals helps tighten overall monetary conditions for demand moderation, strengthening inflation targeting credibility.

Negatives:

  • Credit Risks: If higher rates persist, retail and corporate loan defaults could spike, leading to Non-Performing Assets (NPAs) and hurting banks.
  • Capex Slowdown: Sustained high-interest rates may hamper large investments in manufacturing and infrastructure, dampening GDP growth prospects.
  • Financial Exclusion: Poorer sections without credit access may face cash flow pressures if rate hikes sustain, prolonging underlying economic inequality.

In summary, while the overall efficacy of monetary policy transmission is positive, sustained high rates pose risks that may lead to delayed consequences.

Short Term Benefits & Negatives

Positives:

  • Inflation Control: Rapidly passing RBI rate hikes to bank rates helps tighten money supply for consumption and investments, curbing demand-pull pressures.
  • Deposit Stability: Higher interest on savings accounts and fixed deposits avoids major outflows, ensuring stable low-cost funding critical for bank lending.
  • Macro Stability Signals: Quick policy transmission indicates that monetary levers are working appropriately, underscoring confidence in macroeconomic stability.

Negatives:

  • Loan Demand Decline: Sharply higher EMIs may reduce retail credit appetite for homes, autos, etc., as affordability drops, also slowing corporate capex loans demand.
  • Borrower Cash Squeeze: Many bank customers may struggle to service debt obligations like credit cards and personal loans with much steeper rates, risking temporary delinquencies.
  • Consumption Hit: Major retail loan categories involving big-ticket purchases like housing, vehicles, and durables will experience a demand hit from the EMI impact, signaling domestic growth headwinds.

In summary, the next few quarters may see consumption struggle from the accelerated transmission, but stability in deposit funding and positive macro signals help cushion the negative effects to some extent.

Companies Impacted by Faster Rate Hike Pass-Through in India:

Indian Companies to Gain:

  • Private Banks (HDFC Bank, Kotak Mahindra Bank, Bandhan Bank, ICICI Bank, Axis Bank): These banks have a higher proportion of loans linked to external benchmarks like EBLR, allowing them to quickly adjust rates and potentially improve their net interest margins (NIMs) as lending rates rise. Their strong asset quality and capital adequacy further position them to benefit from rising rates.
  • NBFCs with EBLR-linked Lending: NBFCs like Bajaj Finance and Muthoot Finance might see improved profitability if they have significant EBLR-linked loan portfolios, benefiting from faster transmission of higher rates to loan income.
  • Fixed-Income Funds and Debt-Oriented Mutual Funds: Rising interest rates generally benefit these funds as their underlying bond holdings see increased market value and coupon payments. Increased investor interest in debt funds as a hedge against inflation could also boost their inflows.

Indian Companies to Lose (Potentially):

  • Borrowers with Floating-Rate Loans: Businesses and individuals with floating-rate loans, especially those linked to MCLR with longer reset periods, could face higher interest payments, impacting their budgets and debt servicing capability.
  • Small and Medium Enterprises (SMEs): SMEs often rely on bank loans at higher interest rates. Faster rate hikes could further increase their borrowing costs, potentially impacting their profitability and growth.
  • Interest-Sensitive Sectors: Real estate, construction, and consumer durables sectors are particularly sensitive to rising interest rates. Higher borrowing costs could dampen demand and investment in these sectors, impacting companies operating in them.

Global Companies (Limited Impact):

  • Foreign Banks with Indian Operations: Their exposure to the Indian market makes them susceptible to the overall impact of rising interest rates, but the specific impact on individual banks will depend on their loan portfolios and risk management strategies.
  • Global Investment Banks: While higher interest rates might initially dampen foreign investments in India, it could also create opportunities for structured products and hedging strategies, potentially benefiting global investment banks with strong India presence.

Market Sentiment:

The faster rate hike transmission is likely to have a mixed impact on market sentiment.

  • Positive: Banks, NBFCs, and debt funds might see increased investor interest due to potential profitability gains.
  • Negative: Borrowers, interest-sensitive sectors, and SMEs could face headwinds and uncertainties, potentially impacting their stock prices.
  • Neutral: Global companies may adopt a wait-and-see approach, cautiously monitoring the unfolding economic scenario before making significant investment decisions.

Remember, this analysis is based on limited information and may not capture all factors. Please conduct further research and consider your individual circumstances before making any investment decisions.

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