The economy having caught a viral fever, the mandarins are administering various doses for recuperation. The Reserve Bank of India (RBI) cut the signal for interest rates, which is the overnight repo rate, by 1.1% from February 2019 till the previous review meeting on 7 August 2019. The finance minister delivered a “corporate package” worth ₹1.45 trillion on 20 September. And today, RBI delivered another dose: interest rate cut of 0.25%, taking the total rate reduction signal to 1.35% since February 2019. This is significant, given that the repo rate, at 5.15%, is on the lower side by historical standards.
We have been arguing through this column that while RBI has been reducing the signal for interest rates i.e. repo rate, it is not really being transmitted to the real economy. The interest rate on loans taken by the public or corporates has come down by only 0.29% in the period between February and August 2019 against 1.35% of repo rate cut. Action has been taken by RBI: floating rate loans taken from banks from 1 October 2019 will be marked to an external benchmark and not the cost of funds of the bank, which means better transmission of RBI rate signals. Fixed rate loans are still marked to the bank’s cost of funds, known as the marginal cost of funds-based lending rate (MCLR).
The government has been communicating that they expect banks to pass on the lower interest rate signal from RBI to loan rates on the ground, to provide impetus to the economy. However, interest rates on small savings like post office deposits are still on the higher side. This is a hard political issue, as lowering small savings rate will impact the masses. However, if lower rates are to be seriously passed on to the broad system, then the overall interest rate structure in the economy, including small savings rates, has to come down.
What’s the way forward? Inflation is benign, giving scope to RBI to reduce interest rates further. They may be little wary now; the “corporate package” of ₹1.45 trillion may have an impact on the fiscal deficit of the government, which in turn would have an impact on inflation. Anyway, the RBI governor reposed faith in the government’s assertion that they are sticking to the fiscal deficit target announced in the Union budget. As the scenario pans out, including inflation, the beleaguered growth rate of the economy, among others, RBI is expected to take more action on easing interest rates.
The impact of Friday’s rate cut on your investment portfolio is positive. The move reduces the cost of funds for corporates, which improves the bottom line and is, therefore, conducive for equity stocks. It is positive for your debt investments as well; as interest rates come down, prices of your bond holdings improve. To be borne in mind, we are close to the end of the interest rate cut cycle. On your bond investments, it is advisable to take exposure to relatively short maturity bonds and funds as the volatility risk will be that much lower. The longer the maturity, higher is the scope for volatility. Net-net, bonds and funds of maturity up to three to four years will be relatively stable in performance and are advisable on the risk-reward outlook.