>Deposit Rate Hikes in the Offing – A Process of Normalization

Quick Comment: Over the weekend, HDFC Bank raised deposit rates for 1-2 year deposits by 25-50 bps. We expect other banks to start raising rates too – moreover, the first 1-2 deposit rate hikes may come with no hike in lending rates (similar to the last cycle of rate hikes effected by banks).

When interest rates started coming down, Indian banks (especially SOE banks) had been averse to cutting deposit rates: This was the key cause of intense downward NIM pressure banks saw in the first half of CY2009. However, they made up for that inertia, by cutting rates extremely aggressively since the beginning of 2009 as liquidity increased in the system. This caused lending spread (PLR- 1 year deposit rate) to move up sharply last year.

Currently rates offered on 1 year deposits are about 6%: This is unsustainable in India, where there are alternative investment options for individuals offering around 8%. Moreover, with inflation running at higher levels (WPI, core CPI, CPI are all higher), investors are making negative real returns. This caused deposit growth to slow down – term deposits in India are now growing at around 16%, the lowest rate since 2006.

Lending growth has picked up, implying a significant jump in incremental credit deposit ratios: If we look at ICDR on a 3-month trailing basis, this bottomed around July – August and has since picked up. On the last data point, it is running above 100%. This is causing a reduction in excess liquidity, which can allow banks to normalize deposit rates again.

What does this mean for our NIM assumptions – We were not building continuation of the current high spreads on lending to continue. Hence, no change in NIM’s. Moreover, rising rates are good for banks with strong liability franchises.

To read the full report: INDIAN FINANCIAL SERVICES