RBI rate hike effect: Mortgage borrowers face the big squeeze

The Indian central bank's monetary shock therapy has left the country's newly leveraged middle class gasping for breath. Last weekend, ICICI Bank Ltd., which commands a 30 per cent share of retail lending in India, raised the benchmark interest rate on all floating-rate loans, including mortgages, by 1 percentage point to 12.75 percent.

This move came on top of a similar increase in February, and a half-percentage-point one in December. Each time, the trigger was an unexpected preemption of financial-system liquidity by the central bank.

This steep escalation in the cost of home finance is deeply unsettling. Any monetary policy that causes real, long-term rates to move so drastically can't be called a successful one.

Will it reduce demand for new mortgages? Of course it will. And once that happens, the Reserve Bank of India might even pat itself on the back for containing runaway growth in bank credit. Goldman Sachs Group said the rate of expansion in unsubsidised commercial credit in India will slow to about 20 per cent from 30 per cent at present.

Yet, the victory will come at a heavy price. A new homeowner who took out a 2 million-rupee ($46,200), 15-year variable-rate mortgage, say, two months ago was better off as a tenant. His loan's maturity, according to ICICI Bank's "impact calculator,'' has increased by about eight years.

Punishment for Homeowners
To the extent the large increase in home-loan rates are a direct result of monetary tightening, one wonders why the central bank is punishing homeowners even as the government is rewarding them with juicy tax exemptions. There ought to be a better way to contain credit growth in the economy rather than by bulldozing the hapless middle class, which doesn't have the stomach for this kind of volatility.

Mortgage lending, which accounts for about 14 percent of the total unsubsidised commercial credit, is growing at an annual rate of about 32 percent, according to the latest available data.

Some Indian banks have significantly more exposure to mortgage lending than others. Home loans account for 51 per cent of ICICI Bank's $27 billion in retail assets. Credit growth, whose pace has barely slackened from about 33 per cent a year ago, has prompted the central bank to bring out the heavy artillery.

In the past four months, the Reserve Bank has mandated as many as three increases in the cash-reserve ratio, or the proportion of deposits that commercial lenders must keep with the central bank as cash. Between December and now, the reserve requirement has risen 1.5 percentage points, with the most recent 50-basis-point increase announced on March 30.

Removal of Liquidity
This preemption of cash has removed about $10 billion of liquidity from the banking system.

As a result, lenders such as ICICI are now scurrying to woo depositors by promising them higher interest rates. The rising cost of attracting deposits is, in turn, passed on to the retail borrowers, who are getting squeezed. Better coordination between fiscal and monetary policy could have avoided the discomfort.

The Indian government gives tax breaks that knock off a significant chunk of the effective borrowing cost on home loans. By scrapping, reducing, or at the very least, suspending the tax breaks for new mortgages, the government could have curbed demand for fresh loans without hurting existing borrowers.

A 200-basis-point increase in a mortgage rate in less than two months is unbearable even in a high-wage-growth country such as India. It translates into a 20 percent jump in what a family has to pay the bank every month, according to Credit Suisse Group research.

No Relief
The other option, equally unpleasant, is for borrowers to increase their own equity.

According to a report last month by Credit Suisse Group's Mumbai-based analyst Aditya Singhania, a prospective homebuyer who was expecting to make a 20 percent initial payment must come up with an additional 15 percent of the loan value to keep the monthly payout unchanged from what he had budgeted for before a 200-basis-point surge in the cost of capital. Banks in India have tried to keep mortgage defaults low.

To that end, they have held monthly repayments constant for existing variable-rate borrowers and increased the duration of the loans. This strategy is now reaching its limit.

With monthly installments unable to cover interest costs, banks will have to seek more cash from the borrowers, who will have to curb other household expenditure to find the extra money.

No Rate Cuts
"We estimate that the current policy-tightening cycle is likely to reduce consumer demand considerably,'' Goldman Sachs economists Tushar Poddar and Mark Tan said in their report.

Even then, there's very little chance of the Reserve Bank easing up on its hawkish stance in a hurry.