Need more liquidity if rate cuts are to be passed on
While the consensus is on a 25 basis points (bps) cut in repo rates on Tuesday when the Reserve Bank of India (RBI) meets to review monetary policy, there is an outside chance the cut could be sharper, at 50 bps. After all, inflation has been brought down to well within targeted levels of 6% by January 2016, the government has promised to rein in the fiscal deficit at 3.5% for FY17, interest rates on small-savings schemes have been trimmed and the US Fed has indicated the rise in the federal funds rates would be calibrated. Most important, GDP growth still looks sluggish; going by the old GDP series, the economy grew at an anaemic 4.6% in the three months to December, well below the potential 7-7.5%, though a normal monsoon will help push growth up by 75-100 bps. And factory output between April and January averaged just 2.7%, levels similar to that in FY15.
That would have to be the most compelling reason to snip 50 basis points off the repo, currently at 6.75%. To be sure, lower lending rates aren’t going to get companies to start adding capacity immediately. In a treacherous world, where most economies are slowing, it is hard to tell where prices of commodities are headed even in the near-term—companies can’t be expected to take on projects when they are unable to read the demand outlook clearly. And in any case there appears to be ample capacity in the economy that is not being used and can be cranked up should demand start rising faster. The high real interest rates, currently in the 11-12% levels, only make things worse since projects look that much more unviable. However, should banks be able to lower lending rates, it will ease some of the pressure on corporate bottomlines, enabling them to, a year or two down the line, think of investing. Moreover, it is possible consumers—especially beneficiaries of the 7th Pay Commission hike—will be spurred to purchase big-ticket items such as houses once interest rates are lowered.
While RBI has cut the repo by 125 bps since January, 2015, banks have lowered their base rates by just between 50-60 basis points. The transmission has been partial since banks were looking to realign deposit rates so as to protect their margins though in the money markets rates have dropped by 100-125 basis points. Deposit rates are now down by about 110-115 basis points since the cycle turned. However, less than adequate liquidity also seems to have impeded transmission and the central bank has addressed the issue, to some extent, via Open Market Operations (OMO). However, economists expect the money market deficit to be at anywhere between R80,000-100,000 crore in April-May unless forex flows are abundant as they have been in March with $4 billion flowing into stocks. Although we are in slack season, and benchmark yields have come off sharply, the central bank needs to reassure the markets that enough liquidity will be forthcoming if it wants its rate cuts to get transmitted.