How Much of a Monetary Boost Will We See from the RBI?

The October monetary policy review will likely throw up a rate cut, but how long can this cycle continue? 

In one of his recent press conferences, Reserve Bank of India (RBI) governor Shaktikanta Das indicated that there’s room for more rate cuts, which provides a strong signal to India’s slowing economy that more monetary boosts are in the offing. 

Though the governor is only one representative of the six-member monetary policy committee (MPC), the minutes of its previous meeting suggest that the downward trajectory of the policy rates could continue. Also, the recently released GDP data for the first quarter of FY’20 indicate that India’s economy has slowed down to a six-year low. With inflation remaining benign (below 4% since August 2018), it provides additional leeway to the MPC members to put a heavier thrust on growth numbers while deciding. 

Since the previous MPC meeting, the finance ministry has also stepped up its ante and released a slew of measures which to some extent could also weigh on the finances of the government. Given this backdrop, the larger question remains as to whether the rate cut cycle will continue in this policy as well. Or, with almost 110 bps rate cut and a number of fiscal measures (mostly supply-side measures to correct demand-side issues), is it time to hold the baton and let the economy react?

File photo of RBI governor Shaktikanta Das. Photo: PTI

How much space does the RBI have?

In a recent column, IDFC Institute research director Niranjan Rajadhyaksha takes the popular “Taylor Rule” to suggest that India’s repo rate should be around 4%. The Taylor Rule, which works on a number of assumptions, helps in arriving at the repo rate based upon a host of variables – neutral interest rate (assumed to be 1.25%), output gap, inflation gap and equal weights given to interest and growth numbers. 

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With the current repo rate at 5.4%, this gives a significant monetary space for RBI to implement a rate cut. I too have argued, in my earlier articles, based on the idea of India’s high real interest rates, that monetary space is available. 

Rate cut cycle – A blast from the past

Since the 2007 financial crisis, the RBI has on two occasions undertaken rate cuts across successive months or policies. The seven months between October 2008 and April 2009 saw a rate cut of 4.25 percentage points to revive the economy, which had been hit by a global financial shock. The other period is the nine months commencing January 2015, which saw a downward rate cycle of 125 bps. 

Interestingly, during this period, India was growing in real terms by more than 7%, but it was retail inflation which was significantly lower than the inflation target (8%) set at that the time. 

However, it’s difficult to compare both time periods because the RBI used to follow a “multiple-indicators approach” (having one inflation target). It has since shifted to targeting “inflation targeting”, focusing on a ‘band’ instead. But the important point is that the RBI gave a monetary stimulus during 2015, when inflation was below target, amidst robust growth. 

On the other hand, with the current scenario portraying a slowdown, a monetary stimulus looks more justified. 

Liquidity and transmission dynamics

The banking system has been flush with liquidity since June 2019 and has remained more than Rs 1 lakh crore on most days. This surplus should have supported transmission to some extent, but numbers don’t reflect the same completely. If we simply try to analyse the movement in lending rates on fresh loans (available till July 2019) coupled with the median marginal cost of lending rates (till August 2019) and compare the same with the movement of the RBI repo rate, we can conclude that transmission has been lower.

The repo rate was reduced by 50 bps in a span of two months (February: 25 bps, April: 25 bps) while the lending rate (for fresh loans) for all SCBs has reduced by 20 bps while MCLR has reduced by 30 bps. Interestingly, the weighted average lending rates on fresh loans for all SCBs have actually increased from June 2019 to July 2019. For better transmission, the RBI has mandated external benchmarking of new loans to retail, micro and small enterprises from October 1. This nudge has been backed by the finance ministry repeatedly. 

In a recent column on external benchmarking of loans, CARE Ratings chief economist Madan Sabnavis has made a pertinent point that linking assets to benchmarks and not the liabilities will strain the banks P/L.

The problem of lending

Despite the continuous monetary stimulus in the form of rate cut and partial policy transmission, the incremental bank credit during the current fiscal (April to 13 September) in the economy continues to remain in the negative territory. Sectoral credit data from RBI (available till July 2019) shows that incremental bank credit to industries and services (which accounts for 60% of non-food credit) has witnessed contraction of 3% and 4.3% respectively. 

The point to ponder here is whether lower lending activities are a demand-side or a supply-side concern? If it is a demand-side issue, then lowering interest rates could propel aggregate demand in the economy but if it is a supply-side issue, then it will call for some other makeovers in the banks. 

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Since the last monetary policy, there have been a number of announcements from the finance ministry to address the growth slowdown. One of them has been the option available to corporates to voluntarily apply a lower tax rate on their profits contingent on not availing exemptions. This has multi-fold consequences ranging from financing the budget, additional market borrowings and the same is reflected in higher GSec yields. 

It is evident from the above analysis that MPC will give another monetary boost weighing growth concerns. A 25 bps rate cut, keeping both inflation and growth dynamics in mind looks on the cards.  

With so many announcements (both monetary and fiscal), there has to be a pause button somewhere down the line. The failed student (economy) has received a number of remedial classes from both its teachers (RBI and finance ministry). Going forward, the teachers should wait and watch while the student should stand the test of time.

Sushant Hede is associate economist at CARE Ratings. Views expressed are personal.