We are at an interesting juncture in the economy today, in the context of interest rates. Most times, the point of debate remains that stakeholders expect lower interest rates, while the Reserve Bank of India (RBI) refuses to oblige for the sake of inflation control.
This time both sides – the stakeholders and the RBI’s Monetary Policy Committee (MPC) are more or less on the same page. Inflation is under control, GDP growth rate is a question mark and the MPC has reduced rates twice, in February and April, by 25 basis points each time.
Going forward, there is an expectation that the policy repo rate would be reduced further, with GDP growth data coming under the scanner and high-frequency indicators pointing to a slowdown.
The next meeting of the RBI MPC is scheduled for June 06. Going by the historically high real interest rates, and needs of industry and personal loan off-take, there is a case for policy repo rate reduction from 6 percent to 5.75 percent. However, there are various considerations due to which the MPC may pause and postpone the rate cut decision until the next meeting on August 07.
The bigger issue is the transmission of rate cuts. Against the 50 basis point reduction in repo rate this year, an iota has been passed on by banks to deposit and lending rates.
This aspect of the transmission of rate measures to the real economy was largely ignored earlier but came to the fore during the tenure of former RBI Governor Raghuram Rajan. Thus, to facilitate the transmission, Marginal Cost of Funds-based Lending Rate (MCLR) was one of the measures undertaken. Since then, through the tenures of former RBI head Urjit Patel and current Governor Shaktikanta Das, transmission has been in focus.
For some time now, banking system liquidity has been in deficit. Credit off-take from banks has been growing at a buoyant pace, much faster than the growth rate in bank deposits. Against this backdrop, if banks pass on the entire RBI-induced rate cut, loan offtake would be incentivised and growth in deposits would be dis-incentivised, aggravating the issue of liquidity tightness.
RBI has taken action to tackle the banking system liquidity shortage. In FY18-19, through open market operation (OMO) purchase of Government Securities, the RBI has infused almost Rs 3 lakh crore into the system.
In the current financial year, the RBI has completed two forex swap auctions of $5 billion each, infusing approx Rs 70,000 crore. OMO purchases are continuing as well. In spite of all this, the banking system liquidity tightness continues.
Things may improve gradually as the election process ends and the cash component of the economy reduces. It is expected that reducing cash in the economy, flows into the banking system would improve.
However, at this juncture, if the RBI cuts rates on June 06, are banks in a position to pass it on? If not, would the RBI cut again, taking the rate cut to 75 basis points this year?
From an implementation perspective, there is a case to wait for some time and take action when the conditions are conducive for transmission.
There are a couple of other parameters, on which there would be more clarity in August, rather than June.
The fiscal deficit is one of these variables. Higher deficit promotes inflation and also leads to higher government borrowing from the market. As long as the deficit is controlled or within acceptable limits, the RBI MPC will be comfortable easing rates.
Given that the election result will be out on May 23, and it will take time to form the government, and the Union Budget, which will provide clarity on what to expect on the fiscal deficit front, is expected in July.
Another variable is the monsoon. Marginal deficient monsoons and depleted water reserves are projected this year, it has thus become even more relevant to defer till August to have a complete perspective.
To conclude, the case remains for a further policy rate reduction, but the extent and timing is something on which the MPC would deliberate and decide on. The approach of the MPC towards policy rate remains ‘neutral’.