A large part of the loans taken by small borrowers is linked to an external benchmark and, more often, to the repo rate. A rise of 40 basis points (bps) would increase their cost of borrowing by an equivalent amount. For large corporations, lending rates are mostly tied to the marginal cost of funds-based lending rate (MCLR), an internal benchmark where transmission is slower than external benchmarks like repo and treasury bills.
In December, 70.9% of all loans to large industries were linked to the MCLR and 20.4% to external benchmarks. For small businesses, MCLR-linked loans accounted for 24.2% of their total loans, while 69.2% of loans were on external referrals, data from the Reserve Bank of India (RBI) showed. The Monetary Policy Committee (MPC), by raising the repo rate by 40 basis points (bps) on May 4, reversed the decline made during the pandemic in May 2020.
“Companies that are doing very well and seeing good demand will continue to invest, but sectors that see weak demand will have no reason to invest when the cost of capital is high,” said Madan Sabnavis, economist in Chief, Bank of Baroda.
Cement demand, a key indicator of economic activity, when compared to changes in the RBI repo rate, has shown a divergent correlation over the years, according to data analyzed by Nirmal Bang Institutional Equities.
For example, while the repo rate was cut by 40 basis points in 2020-21, cement demand fell by 1%. In contrast, when the rate was cut by 25 basis points in FY18, cement demand jumped 7.1%.
That said, the idea of a rate hike is to dampen demand and, in doing so, control inflationary pressures in the economy.
While fiscal policy controls supply, monetary policy helps correct excess demand.
Experts said that since India’s economy is already experiencing high inflation, consumption will remain subdued and people will spend more on basic necessities.
As a result, overall capacity utilization, which has improved somewhat, will now slow down, hampering future investments.
“The interest rate is just one factor in board discussions on investment decisions,” said Samuel Joseph, Deputy Managing Director, IDBI Bank.
Joseph said that although the investment cycle and interest rates are correlated, it is more related to the real interest rate than the nominal rate.
“The most important factor is the medium-term economic outlook for the sector,” he added.
Analysts have pointed out that the relationship between loan growth and policy rates has not been strong enough, with much depending on the nature of growth and the phase of economic growth.
India recorded strong growth during 2003-08 despite a rising interest rate cycle and weak loan growth after 2014 despite a falling interest rate cycle, analysts at Kotak Institutional Equities in a May 4 memo.
Other experts said the central bank’s attempt to rein in inflation would improve long-term growth prospects. Although the rise should not have an immediate impact on the demand for mortgage loans, the real estate sector is wary and bets on the continuation of the dynamics of mortgage loans. Given that May’s rise is only the beginning of the turn in the rate cycle and the end of favorable interest rates, housing demand, a key driver of personal loan growth, will be watched closely.
“The sector has benefited greatly from low interest rates over the past two years. This rise in key rates will result in higher equivalent monthly payments (EMI) for home loans,” said Gulam Zia, Senior Executive Director of Knight Frank India, a real estate consultancy firm.
Zia, however, hopes improving buyer sentiment, homeownership and strong wage growth will continue to support the housing market.