No case for a rate cut, but Mint St could still do one

To be in the RBI Governor’s shoes these days is no pleasure. He is damned if he cuts, damned if he doesn’t. And yet, on the eve of yet another monetary policy, a weighing of options may clarify things a bit for us.

I had an interesting Indianomics session on CNBC-TV18 in which Union Bank executive director SS Mundhra made two killer points.

First, he pointed out that interest costs as a percentage of total sales had fallen from 14.8 percent in 2008 (when rates were at their highest before the crisis) to 12.9 percent in March 2012 for the universe of manufacturing companies whom the bank services.[caption id=“attachment_506301” align=“alignleft” width=“380”]  RBI Governor D Subbarao. Reuters[/caption]

Mundhra is not alone is saying this. Economists of various hues have proved time and again with strong data support that interest rates are an inconsequential burden. The RBI stated in several of its past monetary policy documents that real interest rates today are lower than they were during the high growth phases of 2006-08.

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I would add that several corporates who came to my shows after this quarter’s results-from Prestige Ltd to the multitude of debt-laden infra biggies-admitted they were stymied by factors quite unconnected to interest rates. TT Jagannathan of Prestige said 14-hour power cuts in Tamil Nadu and the rising costs of power were hurting. The Adanis are worried about coal availability and the evacuation of the power they produce; the Lancos and ADAGs worry about the lack of gas and coal, the JSWs about the lack of ore, and the Tatas about reneged contracts.

Yes, everyone is worried about falling demand as well, so let us address that. Falling demand of a lasting nature usually stems from fewer new jobs or greater fear of loss of existing jobs. So will rate cuts reignite the capex cycle and ensure job creation? The answer from India Inc and bankers is unanimous. Capex decisions last over several rate cycles and no one invests in productive capacities lasting several decades by looking at today’s rates.

Also, as Sanjay Nayar of KKR pointed out in the same Indianomics show, for a large corporate with a good balance-sheet, sourcing money at excellent rates from the global or Indian markets is hardly an issue in these days of lean credit demand. Interest rates, bankers point out, are not as important as growth, when they evaluate a new project. If traffic on a new road will grow at 8 percent rather than 5 percent, that will be more comforting than if the road was built at a lower debt cost, since as we have proved that the cost of money is anyway only a small element in the overall cost of the project.

Then how will rate cuts help? I go to the second point made by Mundhra. While admitting that higher rates have a vastly different impact on different sectors like retail,small and medium enterprises (SMEs), and large corporates, he pointed out that for SMEs with a turnover below Rs 50 crore, high rates have a back-breaking impact. But he left me wondering whether bankers will selectively pass on any liquidity or rate cut advantages to this vulnerable section, or whether they will only use any rate cut gift from the RBI to play the retail market harder, thus fuelling demand in a situation of already high inflation.

Which brings me to the harmful impact of a rate cut. Just a few data points to remember: the wholeslae prices index (WPI) was at 7.8 percent at last count and is definitely expected to go to 8 percent in October and even November. Core inflation (non-food, non-fuel) has held steady at 5.56 percent for the past quarter, much higher than the historical average, and CPI has remained at or above 10 percent for nearly a year. Most analysts believe corporate margin pressure has bottomed out. Which means pricing power is returning. Indeed, as Chetan Ahya pointed out in the same Indianomics show, the latest three-month inflation figure is sharply higher than the previous three-month period.

What’s worse, when we are still working with an unsustainable current account deficit of 4 percent of GDP, any increase in consumption can be seriously harmful.

And what is worse, the government has even stopped making promises to cut subsidies any further. Promises to cut deficits have quietly shifted to other plan and non-plan expenditure control. With no let-up in the creation of fiscal deficit, which stimulates aggregate demand, if the RBI now buys the government’s argument of marching in tandem with fiscal policy, frontloading of rate cuts will be an exercise in a loss of credibility.

But now for the other side. Despite the potential harm a rate cut can cause , and since there is precious little a cut can achieve, methinks the RBI will, and maybe, should, cut rates. I would think a minor 25 basis points repo cut with promises to do more only if inflation and the fisc behave, would be wise.

Why this expectation, despite the decent case against a rate cut? First, it is unwise to be standoffish when the sovereign has stated his preference in the public space. Second, a minor rate cut can’t boost demand much. Third, if sentiment indeed has a role to play in an economic revival, a minor rate cut may at least ward off pessimism. Fourth, banks’ NPAs are becoming truly ugly and a rate cut along with a moral suasion to pass it on, especially to small businesses, may hopefully bring relief not only to SMEs but also to bank bottomlines.

I would still hope the RBI won’t touch the cash reserve ratio (CRR). CRR has a more potent influence on interest rates and must not be resorted to unless the RBI is convinced of the inflation trajectory and of some fiscal improvement. But, frankly, the RBI may do a little more. That is my lurking fear.