With the economy on the upswing post-recession, Indian banks are riding high due to increase in demand for loans and decrease in bad loans. This is expected to show up in the first quarterly results.

The country’s leading lenders, State Bank of India, ICICI Bank and HDFC Bank are witnessing a steady climb in demand for loan over the past few months. Another positive phenomenon seen is the drop in the number of loan defaulters, resulting in improvement in the quality of assets. With the economy predicted to grow beyond the government forecast of 8.5% in the current fiscal, there is a definite surge in confidence level all around.

The intermittent rate hikes by the Reserve Bank of India to combat the spiraling inflation has largely left this feel-good atmosphere untouched. The imminent RBI policy review scheduled for July 27 may also see another marginal rate hike, without any impact on the loan demand.

One of the reasons attributed to this is the presence of ample liquidity in the system. The rate hikes are too small to have any effect on the system. Moreover, the amazing growth of the economy is opening up lucrative avenues for the banking sector. The first quarter also witnessed the unbelievable competition among telecom providers in securing the 3G spectrum and their subsequent clamber to cough up adequate money to pay the spectrum fees to the government.

The superb performance of the manufacturing sector in the last few months has led to a substantial reduction in bad loans and defaulters. The first quarter of the current fiscal saw a drop of 30 basis points in the 10-year benchmark bond yield, which is beneficial from bank’s perspective.

The annual bank credit stands now at 21.7%, which is a tremendous improvement from 9.7% last October.

With the next quarterly policy review due by month end, the Reserve Bank of India has raised the interest rates by 25 basis points. The announcement to this effect was made on Friday after the financial markets closed for the weekend. The central bank attributed the rate hike to runaway inflation that is turning ‘very much generalized’ with demand-side pressures becoming evident.

The RBI raised the reverse repo rate from 3.75% to 4% and repo rate from 5.25% to 5.5%. This is the third time this year that the central bank has increased the interest rates.

The country’s wholesale price inflation (WPI) breached the 10% mark in May, even as industrial production surged ahead with a 17.6% increase in April. Moreover, the government’s recent decision to deregulate petrol prices and partially deregulate diesel prices is believed to further worsen the inflation situation.

“Although entirely justified in terms of long-term fiscal and energy conservation objectives, the recent increase in fuel prices will have an immediate impact of around one percentage point on WPI, with second-round effects being felt in the months ahead,” said a RBI release.

Though RBI announced the rate hike, the banks are in no hurry to raise their base rates. The base rate is the lower limit fixed for each bank below which it cannot lend.

The Finance Minister Pranab Mukherjee expressed his happiness at the latest RBI move. He termed RBI measure as ‘desirable given that core inflation has risen and credit situation is tight’. He is also satisfied that RBI has not hiked the cash reserve ratio (CRR) of banks.

“The measures should contain inflation and anchor inflationary expectations going forward, while not hurting the recovery process,” an RBI statement said. “The Reserve Bank will continue to monitor the macroeconomic conditions, particularly the price situation, and take further action as warranted.”

Economists are expecting a similar policy rate hike during the quarterly policy review scheduled on July 27.

The banking sector’s benchmark, prime lending rate (PLR), had been in the center of controversy for long, which prompted RBI to constitute a panel to look into the issue in detail. According to the panel’s recommendation, the PLR system is being abandoned and a new system based on base rate is being introduced. One of the advantages of base rate system is that it will make lending process more transparent.

O P Bhatt, Chairman, SBI, India’s largest bank said, “The base rate will be transparent. Credit will henceforth revolve around the base rate as it will be the reference rate over which all loans will be priced and it will succeed in monetary transmission.”

One of the perennial complaints against PLR system was that many private sector banks were not passing on the reduction in policy rates to customers, but lose no time when the policy rates are hiked. This equals nullifying the monetary policy. The banks are also accused of favoring their corporate customers at the cost of individual customers and smaller companies, with the latter forced to bear the financial consequences. Many banks are lending lower than even funding cost to their most valuable clients.

A base rate system can solve the existing maladies plaguing the banking sector at present. The base rate is the rate below which a bank cannot lend even to their most favored customers. This is determined after analyzing a bank’s funding cost and operating cost.

With the base rate system coming into effect today, Indian banks will be forced to stop lending below 7%. The base rate for different banks will be in the range of 7%-8.75%, depending on each bank’s funding cost.

The auction of third generation (3G) mobile and broadband licenses was a great success for the Indian government. The successful bidding by telecom companies generated revenues in excess of 1, 00,000 crores for the government which is much more than the planned revenues from the exercise. This is good news for the government but it has created a liquidity crunch as most of the funds with banks and the market has been diverted to the government coffers. In the fortnight ending June 4, the banks lent over 60,000 crore rupees to telecom companies to fund the 3G and broadband auctions. To generate funds of this magnitude banks had to withdraw their investments in liquid mutual fund schemes, this action created further liquidity pressure.

The excess liquidity in the Indian economy started reducing because of this process. Banks in the country were lenders to the central bank, the reserve bank of India (RBI) as they used to park   surplus funds with the RBI. This was the trend for almost a year as banks parked funds under the RBI’s reverse repo auctions. The same banks have now become net borrowers from the central bank due to the need of funds to fund the 3G and broadband spectrum auctions.

The banks are currently borrowing almost 50,000 crores daily from RBI under its liquidity adjustment facility. Last week the central bank bought back government bonds worth 10,000 crores from the market and released an equivalent amount of funds; this was done to improve the liquidity condition. The challenges in Europe which pertain to worsening of government financial positions for few countries in the European Union are adding to the concerns regarding the liquidity crunch. The Euro Zone crisis is having an effect on the foreign investors as they are withdrawing funds from the markets; this is further enhancing the ongoing liquidity problems faced by the Indian economy.

The adverse liquidity conditions will continue till the money that has flown out starts coming back to the economy. This will be possible only when the government starts channelizing the funds back in to the economy via government spending. Right now it is the end of first quarter thus there will be further outflow of funds to the government coffers due to advance tax payments by the corporates. Given the situation and the timing it is likely that the liquidity condition will continue as is for some more time and normalcy in the liquidity conditions will be reinstated only after a while.

Given the current liquidity condition if there is a sudden increase in the credit demand then the RBI will have to take some actions to infuse liquidity in the system. Along with the challenges with liquidity there are concerns with the inflation also. If there is a sudden infusion of liquidity in the system then there may be rise in inflationary pressure. Given that inflation has crossed the dual digit levels it is likely that the central bank may increase the interest rates as this will help control the inflationary challenges being faced.