India Ratings and Research (Ind-Ra) says that the Reserve Bank of India’s (RBI) substantial dividend transfer of Rs 2.11 trillion to the central government is expected to mitigate the ongoing pressure on deposit accretion in the banking system and overall interest rates.
This transfer, coupled with the subsequent government spending, will bolster the central government’s fiscal position, enabling potential additional spending or fiscal consolidation.
However, banks will continue to face structural challenges related to deposit growth in the medium to long term.
In its FY25 credit market outlook, Ind-Ra highlighted that the Indian economy is experiencing coordinated tightening across fiscal, monetary, liquidity, and regulatory fronts, with the combined effects expected to manifest in FY25.
Despite continued fiscal and regulatory tightening, monetary conditions, particularly banking system liquidity, are anticipated to ease. Nonetheless, lending rates are likely to remain elevated, with any reductions becoming evident only in the second half of FY25.
“The dividend transfer by the RBI to the government is likely to reduce the ongoing pressure on the banking system deposit accretion and short-term rates in the system. However, given that credit growth continues to be strong and deposit growth has now been lagging advances growth for the past couple of years, the structural challenges for banks in term of deposit accretion will continue in the medium to long term”, said Karan Gupta, Head and Director Financial Institutions, Ind-Ra.
Ind-Ra projects that the RBI’s Rs 2.1 trillion dividend transfer will enhance liquidity conditions and alleviate the heightened pressure on banking system deposits, thus easing the cost of liabilities for banks in the near term.
This dividend has augmented the base money, providing a stable financial foundation. However, daily liquidity volatility will still be influenced by government spending patterns and forex flows, albeit to a lesser extent.
The agency does not foresee the necessity for open market operations (OMO) sales in FY25, given the base case scenario. The unexpected dividend partially fulfils the natural base money creation requirement for the year.
Furthermore, due to the volatile nature of foreign portfolio investments (FPIs), using durable tools like OMO sales to sterilize such non-durable flows is deemed unnecessary.
According to Ind-Ra, despite RBI’s intervention, the banking system’s liquidity has been strained and volatile, driven by restricted government spending, increased cash circulation, and significant FPI outflows, which have totalled USD 4 billion in the current fiscal year (as of May 27).
Additionally, cash in circulation rose by approximately Rs 1.6 trillion between March 1 and May 10, 2024. As a result, the net liquidity deficit surged to Rs 2.55 trillion on May 21, 2024, representing about 1.5 per cent of net demand and time liabilities.
Banks have struggled to attract deposits in the face of strong credit demand over the past few years, attributed to both long-term structural issues, such as competition from other financial products, and short-term challenges, like insufficient base money creation and government spending patterns.
Post COVID-19, credit demand surged, with average annual credit growth reaching 16-17 per cent, while deposit growth lagged. Public sector banks (PSBs), with an average liquidity deposit ratio (LDR) of around 65 per cent, have been able to support loan growth without corresponding deposit increases.
However, with most PSBs now operating at higher LDR levels (around 75 per cent), they must focus on growing deposits to sustain systemic loan growth.
The increase in policy rates has shifted the deposit mix, leading to a decline in the current account and savings account (CASA) ratio by around 300 basis points from 4QFY22 to 1QFY24, as funds moved to higher-yielding products.
The upward repricing of term deposits has also widened the interest rate gap between term deposits and CASA, making the value of CASA deposits more significant.
Deposit rates in the banking system have varied, but with the base money surge, pressure is expected to ease significantly.
The banking system’s net interest margins are projected to remain flat or see a slight decline in FY25, as banks may start adjusting deposit rates downward ahead of potential rate cuts, which would impact nearly half of their assets immediately.
Ind-Ra’s FY25 banking sector outlook emphasizes the importance of deposit mobilization and maintaining stable net interest margins.
Credit growth is expected to moderate to 15 per cent year-on-year in FY25, due to reduced lending to non-bank financial companies (NBFCs) and the retail sector, offset by a revival in private capital expenditure.
A moderation in short-term rates is expected to benefit certain NBFCs, particularly those with strong credit profiles and shorter-duration assets to approach commercial banks.