Sometimes it seems India is trying too hard to emulate neighbor China. China's central bank recently engineered a cash crunch by tightening its monetary stance, and now the Reserve Bank of India has followed by pulling liquidity from its financial sector.
Of course, there are big differences. Where the People's Bank of China aimed to rein in surging credit, the RBI wants to prop up the weak rupee by raising domestic interest rates.
But the RBI moves threaten to strain India's financial institutions just as the PBOC squeeze strained China's. An index of India's bank shares has fallen by around 6% this week, while the broader Mumbai market is up slightly.
The RBI's actions effectively raise interest rates for bank funding and also include the sale of an additional $2 billion of bonds on top of its regular bond sales. That has sent short-term rates about two percentage points higher making it more expensive for banks to borrow from the wholesale market while also driving down the value of bonds held on bank balance sheets. Nomura notes that loan growth would be likely to slow if the central bank prolongs the tightening.
Likely to be worst hit are banks that rely more on wholesale funding. Yes Bank, for instance, depends on the wholesale market for 64.5% of its funding needs, according to Citi. There could be a bigger impact on government-owned banks such as State Bank of India, the country's largest lender by assets which typically hold more bonds on their balance sheets than private lenders.
In China, the PBOC eventually stepped back into the market to ease the cash crunch. Investors responded by piling back into some of the country's banks Industrial & Commercial Bank of China's shares, for instance, are up around 11% since late June after falling 20% between May 31 and June 25.
So far, the rupee has strengthened less than 1% against the U.S. dollar since the central bank's intervention. A more significant rebound could free the RBI to reverse some of its recent policies. Without the rupee's gain, India's banks will continue to feel the pain.
