RBI Delivers an 'Out-of-the-Box' Rate Cut. What Next?

When will investment revival take place, given the bottlenecks in the transmission mechanism? 

The Reserve Bank of India’s (RBI’s) Monetary Policy Committee (MPC), in its recently announced monetary policy, did not surprise many with the direction of its rate action, but came up with an unprecedented and anomalous rate cut of 35 basis points (bps). 

This rate cut has been the highest since the 50 bps rate cut undertaken by the central bank in September 2015 and the current repo rate (policy rate) of 5.4% is at its lowest level since July 2010. 

The rationale behind the action

Two key points from the policy statement and the subsequent press conference of the governor are critical: First, with the retail inflation numbers continuing to remain benign with no significant upside risks coupled with it remaining in the comfortable target range (4% +/- 2%), there has been a clear shift in the objective (in the previous two policies) of addressing the negative output gap and propping up aggregate demand especially via private investment. 

Secondly, the reiteration by governor Shaktikanta Das about the non-sacrosanctity of rate actions in multiples of 25 bps indicates that the MPC too can think ‘out-of-the-box’ and go against conventional methods. 

The downward revision in RBI’s growth forecast from 7% in the June’19 policy to 6.9% in the current policy along with benign inflation forecasts and moderate inflation expectations propelled the central bank for the rate cut. The important point is the mid-way of 35 bps chosen by the central bank to strike a balance between an inadequate 25 bps and an excessive 50 bps rate cut. Their analysis clearly highlights the slowdown in both consumption and investment drivers at both domestic and global economy which led to the decision of a larger than expected rate cut. 

The imperative point now is what’s in store next from the MPC? With a cumulative rate cut of 110 bps since February 2019, when will the reliance on monetary policy to kick-start the economy end? 

Also, when will investment revival take place given the bottlenecks in the transmission mechanism? 

Transmission bottlenecks

The transmission in the Indian economy happens with a lag of 2-3 quarters and the same has been the case even in this calendar year. The cumulative rate cut of 75 bps since Feb’19 has been transmitted in the financial markets but the weak transmission in the credit market continues. 

The key lending rates, i.e. MCLR and WALR (fresh loans), have moderated by only 29 bps and 20 bps respectively during the period Jan’19 to July’19.

On the other hand, the WALR of outstanding loans have increased during Jan-June’19. The rate cut has completely been transmitted in the financial markets with the GSec yields declining by almost 110 bps while weighted average call rates declining by 77 bps during Jan’19 to July’19.

Table: Monthly average of key rates (%)

  Repo rate WALR (Fresh) WALR (Outstanding) MCLR (Median) GSec yields WACR
Jan-19 6.5 9.97 10.38 8.8 7.44 6.35
Feb-19 6.25 9.81 10.36 8.8 7.35 6.24
Mar-19 6.25 9.73 10.35 8.75 7.34 6.25
Apr-19 6 9.76 10.42 8.74 7.37 6.06
May-19 6 9.86 10.41 8.75 7.24 5.9
Jun-19 5.75 9.68 10.43 8.7 6.91 5.73
Jul-19 5.75     8.6 6.52 5.58
Aug-19 5.4        6.34*  
Diff between Jan-19 and latest (bps) -75 -29 +5 -20 -110 -77

*As of August 5; WALR – Weighted average lending rates, WACR – Weighted average call rates Source: CMIE

So, will another rate of 35 bps help in transmission in the credit markets? Probably at present, the positive commentary from the central bank has been around the “banking system liquidity” which has been in surplus during June-July’19 and at present is in surplus at around Rs 2 lakh crore. 

Liquidity surplus in the economy bodes well for rate cut transmission. However, the “deposit and interest rate conundrum” remains and it would be interesting to see whether banks will lower deposit interest rates (as a first step to reduce lending rates) and still continue to have robust deposit growth. 

Though the challenges surrounding the debt market mutual funds could move investors towards bank deposits, the higher returns on small savings scheme could lead to some substitution effect. 

Will banks budge and cut rates?

State Bank of India has taken the first move by slashing home loan rates by 15 bps across tenors immediately following the RBI announcement. Despite the banking system liquidity being surplus, the reinvigoration of private sector investment will depend not only on cutting lending rates but also on the willingness of the banks to lend to risky borrowers. 

The recently released Q1 results for few banks show another jump in bad loan additions. Weak performance numbers for banks could constraint banks from lowering lending rates and also constraint disbursements. 

The current slowdown in the domestic economy coupled with a restrained fiscal policy has led to over-reliance on the monetary policy to kick-start the subdued demand conditions in the economy. The Economic Survey 2019 has also highlighted real interest rates to different sectors being high. The following chart juxtaposes quarterly real GDP growth, quarterly retail inflation growth (%) and quarter-end real interest rates. 

Real quarterly GDP growth, CPI and real interest rate. Source: Authors calculation, CMIE. (Real int = Quarter end repo rate – quarterly CPI)

The real interest rate at the current inflation level is at 2.33% while the real interest rate considering the inflation forecast of 3.6% given by RBI stands at 1.8%. In recent times when GDP was robust at around 7-8% and inflation at around little above the target of 4%, the real interest rate was at 1.4%-1.5%. This certainly gives the central bank room to manoeuvre a little more with the policy rates. 

To conclude, a positive and anomalous decision from the MPC in its recently announced monetary policy is a right step in bridging the negative output gap in the economy. With inflation remaining benign, there is still scope for a further rate cut, albeit at a gradual pace. 

Though the future course of policy action depends on the future course of incoming data (especially the progress of monsoon, weakness in the rupee and geopolitical and trade uncertainties), an accommodative stance should also look at the “status quo” alternative and be watchful of better transmission and improved bank credit off-take to drive the Indian economy. 

Sushant Hede is Associate Economist at CARE Ratings. Views expressed here are personal.