RBI remains a Cassandra, and the rate cut won't help

The lowering of interest rates by the Reserve Bank of India (RBI) was evidently done to assuage the markets which had already factored in a 25 basis points cut (one quarter of one percent) in the repo rate. There were some ambitious expectations too that the quantum would be double and be spiced with a cash reserve ratio (CRR) cut. The policy statement is clothed with caution which also gets reflected in the macroeconomic projections.

Some questions obviously rise. The first is whether there will be more such cuts in the coming months? Second, will this rate cut help spur the economy at all? Third, when the RBI has sounded more than cautious on the risks to the economy, does the rate cut synchronise with these concerns? Last, as a corollary, should this rate cut have been deferred until such time there was more clarity on the apprehensions expressed by the RBI?

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The future direction of interest rates should typically be downwards since we have seen inflation moving in this direction. Hence there is little reason to expect a change in stance. However, the RBI has admitted that given the problems on the current account deficit, it would not rule out the option of moving in a different direction if it is so warranted.

Linking interest rates to the current account deficit is a new dimension that has been added to the repertoire of explanations provided for maintaining high interest rates in the last year. The rationale is that high interest rates will make Indian debt markets attractive to foreign investors; and domestic companies would continue to access external commercial borrowings (ECBs), which will become relatively less attractive if interest rates come down.

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[caption id=“attachment_754101” align=“alignleft” width=“380”] Will this rate cut help? The answer is a shoulder shrug.. AFP[/caption]

While this cannot be a driving force for monetary policy action, it can certainly support such moves. However, in general one may expect interest rates to move down as long as WPI inflation shows similar tendencies. As the RBI has projected 5 percent end-point inflation in March 2014, it may be expected that there could be another 50 bps cut in rates, provided the road remains even.

Will this rate cut help? The answer is a shoulder shrug. In the past, whenever the repo rate was cut, banks did not respond with alacrity to such changes in lending rates though deposit rates were lowered faster. One must remember that the repo rate is only a signalling mechanism and even if the average repo borrowing is, say, Rs 1 lakh crore a day on a regular basis for a year, the higher cost on account of the repo not being cut by, say, 1 percent is just Rs 1,000 crore. This is a mere drop in the total income of banks, which was over Rs 7 lakh crore in 2011-12. Therefore, the lower cost actually does not affect their profit and loss accounts significantly.

Banks are more concerned about lending in such an environment where their bad loans (non-performing assets) are increasing. Bad loans, when combined with restructured assets, account for 9-10 percent of total advances. Therefore, the risk premium has been increasing, which negates the advantage of low interest rates.

Also there are studies which show that lower interest rates per se do not lead to higher growth as investment is dependent on consumption, which is more on the demand side. In a situation where excess capacity exists and demand is slack for all goods - consumption and capital goods, lower rates may not really spur investment. It would, however, help to lower the cost of holding inventory, which was gradually depleted last year. This would have improved corporate profitability. Therefore, interest rates per se can never be the driver of the economy - especially when it is of the order of just 25 bps.

The fact that the RBI has sounded cautious is interesting. It has said in the policy that: (i) there is an upside risk to inflation, (ii) the CAD can cause a reversal in stance, and (iii) there is limited room for further such cuts. All this does not give a feeling that the prime goal of the RBI, inflation control, is anywhere near being achieved.

CPI inflation is in double digits at 10.4 percent and the older index for industrial workers is over 11 percent. WPI inflation has come down but the earlier numbers have always been revised upwards, which could just mean that even the 5.96 percent for March could just turn out to be higher ultimately. In this situation one can argue that while a rate cut is welcome, it may not have been warranted.

Following this question, the next thought is whether or not this move could have been deferred to a later date? Given that we have a policy every 45 days or so, the RBI could have actually sat back and waited for more clarity on inflation before announcing such a cut. The move would then have been backed by conviction and not in the midst of uncertainty as it is today.

Also this is typically the time when there is less demand for credit - which is why the first half used to be called the slack season (a term which has been disbanded for quite some time now). The only doubt on lowering rates now is what is the RBI to do in case inflation starts rising again in future? Probably this is why the policy has kept the option of increasing rates open for the future.

The RBI has scaled down GDP growth projections to 5.7 percent, which is the lowest official projection:the budget gave a figure of 6.8 percent, the PMEAC 6.4 percent, the Economic Survey (6.1-6.7 percent). Inflation has been projected to come down to 5 percent by March, which should be possible, given the high base effect, though there is still latent inflationary pressure due to the potential for increasing minimum support prices of food in an election year, and increases in global commodity prices, including oil.

Also any fiscal slippage will be bad news for inflation. A hint provided here is that liquidity will be under strain - possible fiscal slippage (as budget is based on higher growth than RBI), lower growth in deposits and higher growth in credit compared with last year. So it could mean more action from the RBI on the liquidity front and bond yields may not really come down as per the tale being narrated.

The RBI surely has been largely predictable in the past keeping in mind the market, but it always has some surprise element - like the very hawkish tone adopted this time. It would be interesting to see what it does in June when the next update is provided.