In the Interest of Consumers

     Print Edition: May 2012

Rising interest rates had been a cause for concern in many households servicing existing loans or planning to borrow money. After a long wait, interest rates are set to moderate. For the first time in three years, the Reserve Bank of India (RBI) has slashed the key policy rate by half a percentage point, or 50 basis points (bps), to add momentum to the country's growth.

The repo rate (at which banks borrow from the RBI) has been reduced from 8.5 per cent to 8 per cent. Consequently, the reverse repo rate (at which the RBI borrows from banks) has also come down from 7.5 per cent to 7 per cent.

The reverse repo rate is pegged at one percentage point lower than the repo rate. The cash reserve ratio (CRR, or the proportion of funds that banks require to deposit with the RBI) has been left unaltered at 4.75 per cent.

The RBI had gradually increased the repo rate from 5 per cent in March 2010 to 8.5 per cent in March 2011, primarily to reign in inflation.

Rising interest rates benefited investors as fixed deposit rates went up, but borrowers had to suffer. Banks were under pressure due to increased risk of bad debt.

High interest rates also reduced consumer spending and investments, hampering the economic growth. This is likely to change soon.

The reduction in the policy rate has enthused the stock market. The Bombay Stock Exchange's Sensex, the bellwether index, moved up by 200 points (1.2 per cent) on the day of the policy announcement. The rate-sensitive sectors, such as real estate, automobiles, consumer goods and banking, will be the main beneficiaries.

"With the rate cut, we can see increase in consumption spending and demand for loans," says Dipen Shah, head of fundamental research at Kotak Securities.

The RBI has also abolished foreclosure charges or pre-payment penalties on home loans extended on floating interest rates. This is expected to create demand for properties and, of course, loans.

"The demand for housing is picking up. If the rate reduction is passed on to the customers, it will create positive sentiments for the sector," says Deepak Shah, director at Sumer Group, a realty developer.

Banks have already started to lower their short-term deposit rates and lending rates.

"Till May-end, liquidity is expected to remain comfortable. This, coupled with a lean credit season, will provide some space for reduction in deposit rates (mostly for short-term deposits) and, in turn, a reduction in lending rates, although with a lag of a fortnight or two," says Ritesh Jain, head of investments at Canara Robeco Asset Management Company.

"On a generalised basis, a 25-bps cut in lending rates seems more probable than a 50-bps cut. In 2012-13, the repo rate can be reduced further by 50-75 bps depending on factors such as inflation, oil prices and impact of tax hikes," he adds.

Investments in government bonds can give higher returns as interest rates and yields decline and their prices go up (due to their inverse relation), thus, resulting in a gain on your bond portfolio. The yield of 10-year government securities (G-Sec) declined by 10 bps to 8.35 per cent on 17 April 2012 after the rate cut announcement.

These gains might be short-lived. In a scenario of steep long-term rates, Jain recommends investing in short-term debt funds as short-term rates are likely to ease a bit.

"In the near future, 10-year G-Sec is expected to offer interest rate of 8.25-8.50 per cent and then go up to 8.5-8.8 per cent due to the high level of borrowings coupled with concerns on subsidies," says Canara Robeco's Jain.

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