It is almost a foregone conclusion that the Reserve Bank of India (RBI) will go for at least 25 bps cut in the repo rate based on what the Monetary Policy Committee (MPC) decides. It is foregone because it is logical given the developments that have taken place in the last month or so. The markets hence should not really be surprised and it is possible that the yields on bonds may not move much. Let us first see what will be driving this decision.
The MPC is officially supposed to target CPI inflation which remains in the comfort zone of 3-3.2 percent which is less than the 4 percent benchmark. While there are some upside risks to inflation, they would not pressurise the headline number though food inflation would tend to increase.
The culprit is onions where the flooding conditions in some parts have destroyed the crop partially which had led to supply shortages. This appears to be a regular phenomenon and hence does not come as a surprise.
The place where all economists and forecasters have gone wrong globally is with respect to crude oil. Doomsday was projected when Iran sent their drones into Saudi Arabia. But the price has actually settled down to the level of $60 mainly due to slack demand and augmentation of supplies from other sources. This could have been a serious threat but is now part of the past. Therefore, one can say with confidence that inflation is definitely not a worry even though there has been some upward movement in food price inflation. Depressed prices of manufactured products due to slack demand have reined in core inflation.
With inflation being less of a worry today, the RBI has now explicitly stated over the last few policies that growth has to be tackled which is in alignment with the government’s concern. The earlier governor Urjit Patel had taken the view that as the mandate given by the Parliament to the MPC was to target inflation, attention could not be drawn away to any other goal in an aggressive manner. But now with growth being the goal, the direction and pace of monetary policy have changed.
There is an acceptance that growth has slowed down. The gross domestic product (GDP) growth of 5 percent in Q1 was an all-time low in five years or so and industrial growth does not look encouraging. The recent negative growth witnessed in the core sector supports the belief that growth is down and needs a push with monetary policy being the core answer.
Can monetary policy alone do the job? The answer is no, and that is why the government has invoked a series of measures to revive the economy. To begin with, they included measures to ease of doing business, bank mergers, support FDI, export incentives, etc. But the real push was the fiscal stimulus involving ‘money’ where the corporate tax rate was reduced to 22 percent and the government has stated that it expects a revenue loss of Rs 1.45 lakh crore. This is a big giveaway and hence the government means business.
The icing was placed last week by the government when the announcement was made that there would be no additional borrowing in the second half of the year even while CAPEX would not be compromised at any stage. Therefore, the possible threat to inflation on account of the fiscal deficit going awry has been assuaged by this announcement which will weigh heavily when the MPC discusses the policy.
In such a situation, it is almost certain that the RBI or rather the MPC will continue with a spree of rate cuts which have aggregated 110 bps so far. A more aggressive cut to 5 percent repo rate cannot also be ruled out. Will it help?
Presently the situation is one typified by low demand for funds as most industries on the consumption side face slack conditions and the capital goods sector is still ticking on government spending with private interest being limited. Therefore, lowering interest rates will not immediately lead to an increase in demand for funds though it would be supportive once the investment cycle picks up.
However, the curious case will relate to retail and SME loans. The RBI notification makes it mandatory for banks to go to the benchmarking method for fixing their lending rates which have been challenging for banks. This is so as a part of the growing loan portfolio of banks has to be benchmarked with a market rate from 1 October while the liabilities have fixed costs. The decision would have been taken on 1 October and hopefully buffered in the expected rate cut on 4 October as these rates would change automatically now.
If the chosen benchmarks were the T-bill or GSec rates, it would be market-determined while any bank using the repo would automatically witness a decline in lending rates. Therefore, this will be a rather interesting phase for banks as they would have to change their lending rates once again based on the developments on the side of the benchmarks.
Looking beyond these rate cuts which have become a habit, a question that is often posed is whether or not monetary policy really matters when it comes to growth. If 110 bps cut in the repo rate has not really turned around the investment cycle, then there is no assurance that another 50 bps will further the cause.
This is the same question that has come up in the west where lower interest rates and quantitative easing have generally failed to deliver in Japan, the Euro region, UK and the USA (to a large extent). Is it that the world economy has gone into a slowdown that will turnaround only gradually with time and that there is no booster shot that can bring in growth? Fiscal stimulus through spending may be more effective until it prods inflation upwards and hence cannot be used without limit. The next few years will require some deeper thinking on these issues.
(The author is chief economist, CARE Ratings)
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Updated Date: Oct 03, 2019 13:22:19 IST