Union commerce and industry minister Nirmala Sitharaman wants the Reserve Bank of India (RBI) to cut its key policy rate, repo rate, by 200 basis points (bps) or 2 percentage points. First of all, the context of Sitharaman saying this is perfectly justified — some respite to the cash starved micro, small and medium enterprises (MSME). But, by demanding such a quantum of rate cut from the central bank at this juncture, the minister is asking for the proverbial moon.
New RBI governor Urjit Patel, the 'silent owl' of the Mint Road who’ll take over the baton from his predecessor, illustrious Raghuram Rajan, on 4 September, will be experiencing low intensity shock waves if he has seen Sitharaman’s demand.
Before examining why, let’s look at what Sitharaman said and her logic to it. “I still hold that the cost of credit in India is high. Undoubtedly, particularly MSMEs which create a lot of jobs contribute to exports... are all hard pressed for money and for them, approaching a bank is no solution because of the prevailing rate of interest. I have no hesitation to say, yes 200 bps, I would strongly recommend,” Sitharaman told reporters in New Delhi.
Indeed, the minister has clear logic and reason for arguing in favor of a sharper rate cut. Small and medium firms, which are the backbone of Indian economy and one of the largest employers to skilled labour, are reeling under severe cash crunch. Unlike top-rated large corporations, they cannot tap the money markets to raise funds. NBFC loans are too costly for tiny entrepreneurs. Commercial bank loans are not different too. Hence, the need for lower interest rates.
"I would want the entire banking system of this country to please be a bit more caring about the industry... it is time now for the Indian economy to have a breath of fresh air. The competitiveness of smaller companies is affected purely because of rate of credit," Sitharaman said. But, banks aren’t very enthusiastic to lend to them since most lenders have burned their fingers with huge non-performing assets (NPAs) emerging from this segment.
Most of the banks have their bottom on fire with high stock of bad loans (especially after the bad loan clean-up exercise initiated by the central bank in September last year). At this stage, banks are more risk averse and will take exposure to low-risk loans such as retail and top-rated corporations, hence they’ll be frowning on listening to Sitharaman’s statement. That explains the stagnant bank loan growth to this segment. Bank lending significantly contracted to the MSME segment between 2015 and 2016 till May with loan growth registering at negative 12.7 per cent to medium-sized companies and negative 6.5 per cent to micro and small companies.
But, the other side of the argument is that RBI is currently in the middle of a tough inflation fight and has been given a retail inflation target of 4 percent (plus/minus 2 percent) by the government until 2021. The central bank’s first target is 5 percent by March 2017. Already, the July CPI (consumer price index) inflation at 6.07 percent crossed the 6 per cent upper band (2 percent on the lower side) agreed between the central bank and the government.
Though there is a likelihood that consumer inflation will ease in post September backed by a good monsoon (thus lower food prices, the key driver of inflation ) received this year, the upside pulls on the food inflation continue to pose major risks to the central bank’s early 2017 target.
Probably, Sitharaman forgot about the agreement between the government and the central bank about the tough 4 percent target. The very reason the RBI has taken a cautious approach in cutting rates is due to the difficulty in achieving this target. Sitharaman is, thus, contradicting the government’s own stance on inflation, by putting pressure on the RBI to cut rates by such a margin. Under the proposed joint monetary policy committee (MPC) mode also, the panel sets the inflation target for the central bank and the latter will have the freedom to tweak the monetary policy course to achieve the target.
The RBI had left its key rate unchanged in bi-monthly review announced on 9 August citing upside risks to inflation. Since January 2015 the central bank has slashed the RBI's key lending rate by 150 basis points. One bps is one hundredth of a percentage point. If inflation eases considerably post September, the central bank might go for a quarter percentage point cut in key rates in October or by year-end.
But it is too early for the central bank to lower the guard on inflation at this stage and even next year, beyond token cuts. This is something most economists have pointed out already. “Even though monsoon has been favorable, inflation is expected to continue to be under pressure," Care rating agency said in a note early this month.
Also, even if RBI goes for a 200 bps rate cut and if banks pass it on to lower lending rates, that’ll break the back of the depositors who park their money in banks. Because, banks don’t cut lending rates alone, they will have to first reduce the deposit rates to manage their costs. This will mean that the common depositors, including the senior citizens, will have to suffer with even lower returns. This is only a hypothetical scenario because banks, in the fist place, are not going to cut their lending rate even if RBI does because of huge NPAs on their books. Hence, it is only a wishful thinking if Sitharaman imagines that a 200 bps RBI rate cut will translate into an identical cut in bank lending rates.
Separately, Sitharaman’s rate cut call (and more that will eventually come from government’s ministers and bureaucrats) highlights the challenge Patel will have to face in his new role.
As Firstpost noted in an earlier article, the government may not have unending patience to tolerate high interest rates in the economy. If the upside risks to inflation picks up substantially in the coming time, the RBI may prefer to continue on pause mode for a longer-than-expected period which may not be necessarily acceptable to the government.
What could worsen things for RBI is that in the proposed joint monetary policy committee (MPC), the government may try to have a strong upper hand, curtailing RBI’s role. Patel, who devised the central bank’s inflation fighting strategy, under the shield of Rajan, stands exposed to lobbying and political pressure as RBI’s new face. Sitharaman’s comment is a good reminder for him to foresee what is in store.
Sitharaman’s demand is in good intention — helping small firms — but she has to find out alternative ways to fund these firms instead of disturbing the central bank’s inflation-fighting plans. Forced rate cuts can take inflation where it was three years ago — in double digits, that’ll break the back of common man. Also, interest rates are only one part of the overall problems MSMEs face. The government can do a lot to facilitate ease of doing business and giving more incentives to exporters.
The bottom line is this: By asking for a 200 bps cut at this stage from the central bank, Sitharaman is asking for the moon.