Manas Chakravarty: No reason to raise interest rates

The increase in mortgage rates by 50 basis points by HDFC and ICICI Bank has come in for sharp criticism by the finance minister, who has said that "they are seizing an opportunity for profit."

The implication is that there wasn't any real need to hike the interest rates and the mortgage lenders are intent on boosting their profits at the expense of the consumer.

On their part, the home loan lenders have been quick to point out that the rise in rates was long overdue, that they had no option but to protect their margins since deposit rates had increased and that the rise in rates was in fact a "lag correction."

Bond yields

The controversy has possibly arisen because of the downward movement of yields in the bond markets in recent weeks, with the yield on 10-year government paper hovering around 6.9 per cent, compared to 7.3 per cent a month ago.

The argument made by those who oppose the rate hike is a simple one "" when interest rates in the bond market are falling, was it necessary to increase housing loan rates at this juncture? The fall in the rate of inflation to a 13-month low of 4.22 per cent has underlined that point.

Others also point to the liquidity in the banking system and the increasingly bullish pronouncements of bond dealers.

Nevertheless, if government bond yields are taken as the benchmark, the mortgage lenders are on firm ground. The yield on the 10-year government bond may have dipped recently, but it has moved up from around 5.6 per cent a year ago to around 6.9 per cent now.

That would justify the 50 basis point hike in home loan rates last November and the recent hike as well. But then, it's not just government bond yields that matter "" the cost of funds for the mortgagors and their margins are more relevant.

Q4 versus Q3

So it's important to find out whether there has, indeed, been a pressure on spreads during the past few months. One way of doing that is to compare the quarterly results for banks and mortgage companies for the quarters ended December 2004 and March 2005.

First, net interest income (NII) has been rising. For ICICI Bank, for instance, NII rose from Rs 733.15 crore in the third quarter of financial year 2005 to Rs 790.10 crore in the fourth quarter.

But the rise in NII is the result of higher volume of business. Interest expended as a percentage of interest earned in fact went up slightly from 69.17 per cent in the third quarter to 69.7 per cent in the fourth quarter.

Net interest margin (NIM) for financial year 2005 as a whole was 2.4 per cent, at the same level as in the first nine months of the year, and well above the 1.9 per cent NIM for financial year 2004.

So the bank did was able to withstand the pressure on interest spreads in the fourth quarter of financial year 2005. And growth in volumes led to substantial increase in NII.

Note also that, on a year-on-year (y-o-y) basis, both the rise in NII and the improvement in interest expended as a percentage of interest earned has been considerable.

Consider the same figures for State Bank of India (SBI), another big mortgage lender. This bank's NII, too, increased from Rs 3,660 crore in the third quarter to Rs 3,950 crore in the fourth quarter.

But interest expended as a percentage of interest earned dipped marginally, from 54.4 per cent in the third quarter to 54.3 per cent in the fourth quarter.

For financial 2005 as a whole, NIM (excluding one-off items) was 3.2 per cent. That's well above the 3.04 per cent for the previous year. NIM actually improved in the fourth quarter to 3.39 per cent from 3.28 per cent in the third quarter.

If you were to consider Bank of Baroda, not only did the NII go up handsomely in the fourth quarter compared to the third quarter, but interest expended as a percentage of interest earned, too, fell by more than 400 basis points.

For these banks, therefore, there is no compelling necessity to raise their interest rates, and home loans constitute a relatively lower proportion of their advances.

Most banks have also been able to grow their NII sizeably. In the fourth quarter, for instance, ICICI Bank had a y-o-y increase of 44.4 per cent in NII, closely followed by HDFC Bank, with a growth in NII of 42.4 per cent.

Among the state-owned banks, Bank of Baroda has been able to grow its NII by 40 per cent in the fourth quarter.

UTI Bank, on the other hand, has serious reason for considering a rate rise. Interest expended as a percentage of interest earned went up from 61.9 per cent in the third quarter to 64.7 per cent.

For HDFC, too, the story has been different. Income from operations was up 15.5 per cent in the fourth quarter, compared to a rise of 13.7 per cent in the third quarter.

But interest expended and other charges, which had moved up by 7 per cent in the third quarter, rose by as much as 14.7 per cent in the fourth.

Nevertheless, NIM for the full year has been maintained at 2.17 per cent, despite the incremental cost of funds rising to 6.5 per cent from around 6 per cent at the beginning of the year.

But HDFC's NIM has fallen to 2.17 per cent for financial year 2005 compared to 2.20 per cent for financial year 2004. Since HDFC depends to a far greater extent on borrowings, it would be one of the first to be affected by rising market rates of interest.

With several banks improving their spreads in the fourth quarter, and with volumes, especially in the home loan market, growing by leaps and bounds, it is unlikely that their profit would be affected if they did not raise interest rates.

Of course, the picture may have changed since March, with the Reserve Bank of India (RBI) hiking the reverse repo rate and it may be a stretch to compare margins on a quarter-by-quarter basis.

Against that, however, are the facts of low inflation and lower market rates this month. It's also true that, in the last six months, the yield on the 10-year government bond has risen by only around 20 basis points.

What's more, analysts are of the opinion that with strong credit growth banks should do very well in the current quarter.

The other reasons

Some analysts believe that the rate hike is nothing but a reflection of a cooling off of the cut-throat competition for housing loans. With an improvement in the economy and a resurgence in loan demand from corporates, banks are no longer as hungry for mortgages as they used to be.

Add to that the fact that ICICI Bank, the most aggressive lender in the mortgage market, has now comfortably established its number one position in the mortgage market. Having gained its market share, it can now afford to be less aggressive.

But perhaps a hike in mortgage rates could be a proactive move, dictated on the basis of higher interest rates in the future? One indication of that is the huge rise in credit in the first two months of the year, at a time when credit growth is usually very low.

Consider, for instance, the fact that credit growth till May 27 this fiscal has been Rs 51,960 crore, compared to Rs 23,211 crore in the corresponding period of last year.

The last time we had credit growth of this magnitude so early in the fiscal year was in 2002-03, when credit rose by Rs 55,025 crore between April 1 and May 30.

However, it's worth noting that the incremental credit deposit ratio during that period was 62.2 per cent, thanks to bank deposits also rising sharply.

In contrast, bank deposit growth this fiscal has not been so good, with the result that the incremental credit-deposit now is much higher, at 88.9 per cent.

If the current trends in deposits and advances continue, and as the government borrowing programme takes off, liquidity with banks could decrease, leading to upward pressure on interest rates.

But that's in the future. As far as the data for the last two quarters show, most banks have been able not only to increase or at least maintain their interest spreads "" while HDFC has been affected marginally "" but the rise in volumes has led to handsome gains.