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Banks selling bond holdings to meet credit demand; loan rates may rise

Rising demand for credit has led Indian banks to dip into their bond investments, potentially squeezing liquidity further and causing borrowing costs to harden, as incremental loan disbursements exceed the pace at which savers are building deposits with high-street lenders.

Banks’ incremental credit to deposit ratio, or the proportion of new deposits that banks use for fresh lending, has gone past the 100% mark. That indicates that banks are liquidating their investment portfolio to meet credit demand, putting further pressure on system liquidity.

To be sure, banks are required by statutes to set aside a part of these funds to ensure the financial system is sufficiently de-risked. To maintain that threshold at aggregate levels and meet the legal mandate, banks are liquidating bond investments in the absence of adequate deposit creation.

Bank credit accelerated at one of the fastest paces since the pandemic at 14%, and the incremental credit deposit ratio is at 113% as of July 15 and has hovered around the 100% mark since May this year, latest Reserve Bank of India (RBI) data indicate. This indicates that interest rates are set to rise further.

“When there is credit offtake, there will be draining out of liquidity and there is always leakage of liquidity through an increase in currency in circulation,” RBI Governor Shaktikanta Das said in a banking seminar last fortnight. “We are also increasing our policy rates. So, going forward, the banks have already started adjusting their asset prices.”

On the liability side, too, some banks have started increasing the deposit rates. The latest RBI data suggest the weighted average domestic term deposit rate on outstanding rupee instruments at commercial banks increased 4 basis points in May to 5.07% and by 6 basis points in June, following the 90 basis-point increase in benchmark policy repo rates during the period. One basis point is 0.01%.

“Going forward, when there is a requirement for liquidity, the banks will steadily and slowly increase the deposit rates,” Governor Das had said two weeks ago. “When we increase the policy rate, it also impacts the deposit rates in the system on the liability side. There is transmission time but eventually, it will transmit to deposit rates also.”

The central bank’s monetary policy committee is expected to vote for around a 50-basis point increase when it meets later this week as consumer inflation continues to remain above the target band of 6%. The policy rate is currently at 4.9%, 25 bps below the pre-pandemic rate of 5.15%.

To be sure, the incremental investment deposit ratio has remained below the 50% mark most of the fortnights in the current financial year so far, indicating that banks are going slow on bond investments.

Economists also attribute a pick-up in credit demand to the tightening of liquidity in the system. The system liquidity surplus has averaged ₹1.3 lakh crore in the current fortnight, compared with ₹2.7 lakh crore surplus seen in the previous fortnight.

One of the factors contributing to tighter liquidity is that credit accretion is happening at a faster pace, according to Dipanwita Majumdar, economist,


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