Demand for bank loans in India is coming back to life but because loan growth is sluggish, the central bank will take time to tighten monetary policy in spite of a pick-up in inflation. As growth in Asia's third-largest economy gathers speed after the downturn, the central bank's desire to raise interest rates may be limited by how well demand for financing is picking up.
Credit growth will be the data to watch and that is why the central bank is likely to raise bank reserves requirements as a first step on Jan. 29, rather than lift interest rates and run the risk of snuffing out what signs of demand there are.
China's loan growth is believed to have risen sharply in January, pushing authorities to act sooner than expected. The Chinese central bank said on Tuesday it will lift bank reserve requirements for the first time since June 2008 - a move most analysts say will have little impact on growth or earnings.
India's banks are liquid enough to cope with higher reserve requirements and have pledged to keep lending rates on hold for a couple of months regardless of what the central bank does. "The credit side is an important reason why the tightening will not be aggressive," said Rajeev Malik, an economist at Macquarie in Singapore.
He expects the Reserve Bank of India to raise the cash reserve ratio by 50 basis points to 5.5 percent but hold off from raising rates until March or April. "RBI doesn't want to slow down the whole credit cycle, which is only now beginning to regain momentum." While the RBI's first tightening is expected to be moderate, it will pave the way for steady and increasingly forceful steps in following months once credit growth recovers.
Bank lending growth slowed to below 10 percent in October compared with a year earlier from highs of around 30 percent two years ago. In the two weeks to Jan. 1, bank loans rose 13.7 percent. Banks, saddled with costly deposits, did not match the RBI's 425 basis point cut in rates between October 2008 and April 2009. That should give them leeway before needing to raise their rates.
Commercial banks lend to top clients at 7 percent to 8 percent a year and offer 6 percent to 6.25 pct for one-year deposits. They have only recently turned more aggressive in winning business, for example by competing on home and car loans. Many economists and bankers expect banks' cash reserve ratio - the level of deposits banks must keep at the central bank - to rise by 50 basis points at the central bank's quarterly policy review on Jan. 29.
That would drain some excess liquidity in the system. However, the chairman of State Bank of India, the country's biggest bank, does not expect an increase in the CRR, saying such a move was untimely given that credit growth was improving and excess funds would be disbursed in coming quarters. Economists and bankers are divided over when exactly the RBI will begin raising policy lending rates but market consensus points to a move by the end of April.
Banks, sitting on excess cash are earning 3.25 percent from deposits at the central bank, would rather lend at 8 percent to 9 percent and cannot afford to scare borrowers by lifting rates. "If CRR is hiked, to some extent there will be some impact on our cost of funds. But at the end of the day we will have to deploy our funds," said M.V. Nair, chairman and managing director of state-run Union Bank of India.
"My own reading is considering the liquidity in the system, and credit growth that is quite slow, banks won't hike lending rates till March." Symbolic start Food prices are expected by some economists to drive headline wholesale inflation to 8 percent by the end of March and with economic growth at 7.9 percent in the September quarter, the RBI needs to begin its retreat from crisis policies.
At the same time, the central bank is under heavy pressure from the government not to derail growth momentum. "There's a strong case for a debut rate hike in order to bring rates out of the financial lifeboat position they are in at the moment," said Philip Wyatt, an economist at UBS in Hong Kong. He expects the RBI to begin tightening rates this month.
While supply-side bottlenecks have driven inflation to date, demand side factors are beginning to surface and will drive more aggressive monetary policy. Some manufacturers have already increased prices. In late November, cement companies raised prices by between 8 rupees and 10 rupees ($0.18-$0.22) per 50 kg (110 lb) bag, reflecting infrastructure demand. Steel companies are likely to follow suit this month, given a revival in demand and a sharp increase in input prices globally.
Wyatt said credit growth will dictate further tightening. "From January onwards, how quickly they continue to tighten is going to be more and more driven not so much by the economic recovery but by how quickly banks expand their loan books."
GROWTH FOCUS
Bankers expect credit growth in the financial year to March of around 14 percent to 15 percent, compared with the RBI's projection of 18 percent. Loan growth could reach between 20 percent and 22 percent or more in the fiscal year that starts in April. Economic growth slowed to 6.7 percent in the last fiscal year after three years of expansion at 9 percent or more, and the government is eager to return to a high growth path, partly to lessen poverty.
Officials expect growth this year at about 7 percent, and economists forecast the economy to return to growth of 8 percent next year, thanks to domestic demand and recovering exports. India along with South Korea is expected to be the first Group of 20 economy to follow Australia and raise interest rates as it recovers from the global downturn.