Banks have increased interest rates on their loans as well as on their deposits. A simple explanation is that the Reserve Bank of India (RBI) recently raised the repo rate by 90 basis points (bps) to 4.9%. The repo rate is the interest rate at which RBI lends to banks. A basis point is one hundredth of a percentage.
The main reason for the rise in interest rates is the increase in the one-year incremental credit-to-deposit ratio. The additional credit deposit ratio as of April 9, 2021 was approximately 37%. This meant that of each ₹100 of deposits raised by banks in the year preceding this date, only ₹37 had been granted in the form of a loan
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This ratio has steadily increased since then and stood at approximately 111% as of June 17. This meant that of each ₹100 of deposits raised by banks in the year preceding June 17, ₹111 had been granted in the form of a loan. Simply put, last year banks made more loans than they took in deposits.
Of course, they could do this using the deposits they had borrowed before last year. However, at the same time, they used other sources to finance these loans.
One of the main reasons for this is the resumption of business credit. Overall lending to industry in May was up 8.7% year-on-year, with micro and small industry lending up 33% and medium-sized business lending up 49.3% . In comparison, in May 2021, the situation was rather stable, with loans to the sector increasing by only 0.2%.
At the same time, retail loan growth is occurring at a faster rate today than a year ago. Personal loans rose 16.4% in May, surpassing the 12.8% gain recorded the previous month.
As loans have increased, the need to fund loans with deposits has also increased. In the process, interest rates rose. Simultaneously, the excess money in the financial system has also diminished. In the aftermath of the pandemic, the RBI printed and injected money into the financial system to drive down interest rates to help government, businesses and individuals borrow at lower interest rates . The idea was to help fuel consumption and stimulate economic recovery.
The cash surplus as of July 3 was ₹2.8 trillion. At its peak, in early September 2021, it amounted to more than ₹9.2 trillion.
The RBI, in its fight against inflation, has gradually withdrawn this excess money from the financial system. It also drove up interest rates.
The conclusion we can draw from this is quite tricky. The RBI wants interest rates to rise. However, as interest rates rose, they rose because bank lending picked up.
Clearly, the economy as a whole is doing much better now than it did this time last year. So the whole idea behind the RBI wanting to raise interest rates is to slow loan growth and in doing so limit demand. It is hoped that a fall in demand will lead to a fall in inflation, but this is not yet the case.
This tells us that rising interest rates do not always prevent businesses and individuals from borrowing and that it depends more on how they feel about their economic future at any given time. Clearly, there is more optimism right now than a year ago.
However, it is also too early in the cycle of rising interest rates. Will this optimism continue as the RBI and other central banks continue to raise interest rates to control inflation? That remains to be seen.
