Story Of The Week

RBI’s Strategic Move: Repo Rate Cut and Its Economic Implications

Time to unshackle growth

Cut, no cut. Hike, no hike. Dovish, hawkish. Before each monetary policy announcement, market try to price in various permutations and combinations of policy biases and react accordingly. Same happened this time, when the Reserve Bank of India was about to announce its fourth bi-monthly monetary policy. Out of 51 economists surveyed; 45 came out with lowering of 25 basis points (bps) and only 1 came with 50 bps. The decision came as whiff of fresh air in a season of stress-revitalize hopes for businessmen, households and the government. The rate cut is more than welcome by all commercial banks, manufacturers and common people. And, so what could have been a better topic than rate cut to discuss in our “Story of the Week section.

Introduction:

The Reserve Bank of India (RBI) on 29th September 2015 lowered the benchmark repo rate by 50 basis points to 6.75 percent; rate cut was deeper than expected from a man who’s made the war on inflation his main focus. Dr. Raghuram Rajan, current governor of the Reserve Bank of India announced his new move to unshackle growth of the economy while keeping the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR) unchanged at 4 percent and 21.5 percent respectively. In 4th bi-monthly monetary policy, he also emphasizes in bringing inflation down to 4.8% by the end of March 2017. From January 2015, 125bps has been lowered by the RBI and now it intends to work with the government to ensure that commercial banks pass on the benefit to the customer to bolster the economy.

 

Reasons for slashing interest rate:

There are many reasons behind plummeting of interest rate by the Reserve Bank of India in its 4th bi-monthly monetary policies.

  • Consumer Price Index (CPI): Lower prices of essential commodities such as crude oil, of which India is a larger importer have helped India in regulating the inflation. Inflation has been the major issue of Indian economy which has even led to topple government in India. CPI is expected to reach below 5.8% in the FY-16 and the vision of lowering it to 4.8% in the FY-17.
  • Whole Sale Price Index (WPI): Wholesale prices meanwhile have been falling more sharply, in line with the deflationary trend in other parts of the world including China. It is negative since October 2014.
  • GDP Growth: India is third largest economy in Asia and third largest by PPP in world. It is one of the world’s fastest growing economies although growth activity has recently slowed. The slowdowns in China as well as market ructions are a clear risk. With global growth and trade slower than initial expectations of various economists and organizations, a continuing lack of appetite for new investment in the private sector, the constraint imposed by stressed assets on bank lending and waning business confidence has led the RBI decrease the rate more than market’s expectations. The output growth projected for 2015-16 is marked down slightly to 7.4 per cent from 7.6 per cent earlier which has led question mark on India achieving a target of US $ 5 trillion in next 10 years from now.
  • Manufacturing Growth: Despite of “Make in India” campaign led by our honorable Prime Minister Mr. Narendra Modi, growth in the manufacturing sector has been patchy in recent years. All the manufacturing sectors like car making, home appliances, etc are humming. Despite of trying to improve the ease of doing business, removing red-tape and upbringing red carpet culture for the manufacturing sectors, the factors like weakening of external demand, suggesting a more persistent drag from lower exports and cheaper imports due to global overcapacity. This all external factors have led to decelerating new orders, under-utilization of domestic capacity and a rising ratio of finished goods inventories to sale.
  • The RBI’s job is not merely to fight inflation but also guard the health of the banking system. A big rate cut will give banks huge treasury gains as the valuations of government securities held in their portfolios will rise. These profits can then be booked in the P&L accounts, allowing banks to clean up their bad loans portfolio by writing-off some of the worst cases, and providing more for the rest.

Impact on the Indian Economy:

  • Economy: Dwindling of interest rate by the central bank can act as culmination of tussle between the government and the corporate India regarding reasons of not investing in the economy. The corporate keep investment at arm’s length due to the ease of doing business and high interest rates because it tends to impact the cost and viability of the project. Now with lower interest rate, government can woo corporate to invest in order to boost up the economy by announcing some fiscal policy changes.
  • Mortgage:Lower interest rates would directly impact all type of mortgages like housing loan, car loan, and personal loans. It is expected to push demand in these segments, which will have a cascading impact on the entire economy. The State Bank of India (SBI), the largest bank in India, took the lead in driving down interest rate for borrowers and cut rate by 40 bps to 9.30% thus making homes and cars affordable.
  • Equity Markets: Equity markets can look forward to gain for numerous reasons. First, the impact on consumption on account of lower interest rate will be positive which will ensure better top-line growth. Lower interest rate outlay also means high profit and thus better valuations. It will also confirm that money will move to equity market from lower yielding debt instruments. It will improve the return on equity for companies. If the debt funding of a project is 70 per cent, then a 25-30 basis point cut would lift the equity return by 0.6-0.7 percentage points, which is a good increase in return.
  • Realty sector: The realty sector can hope for a new phase of growth after the RBI move to cut interest rate by 0.50 per cent and developers have asked the banks to pass on the benefits to home loan borrowers that would help in reviving housing demand during upcoming festive seasons. For Indian families, festival assumes a tremendous significance and people tend to buy property and all other commodities during the festivals. The festive season will begin with Navratri soon followed by Dusshera and Diwali. With the rate cut, there is expectation of change in market sentiments benefiting the large number of home buyers and various stake holders of real estate in India.
  • Auto sector: Lowering interest rate acts as a balm for anxious markets & celebration for fixed income markets. In India, as 65% of car sales are financed & the rate cut can bolster auto sector to meet 15-20% sales growth in the festive season because reduction in interest rate will reduce cost of ownership & also help automakers to get more customers. This Pre-Dusshera / Diwali gift will lift the festive demand and will help the auto sector to achieve the demand led growth in the second half of the year.
  •  Savings:One of the first rates that all banks generally cut when the RBI announces a rate cut is in deposit rates. Banks do not want to take the risk of raising high-cost funds at a time when the borrowing rates are falling. Saving rates in all formats like savings bank account or fixed deposit will go down from investors. Money markets which are the first to react will see their interest rates fall.
  • Currency:Decreasing interest rate can be threat to currency rates because parity in interest rate is the reason behind balancing of currency rates. Lower interest rates will not attract capital which is looking for higher yields, which would mean that the currency would weaken. All the major economies tend to invest in India due to high interest rate in the country. If the Federal Reserve, the central bank of the United States (US), opts to increase interest rate, the differential between the US and India will reduce further, which will result in further fall in currency.

The Road ahead:

Going forward, with RBI expecting CPI to fall towards 4.8% by 2017, there may be room for further 25-50 bps rate cut in 2016. But, the rate cut opens up a question – If the commodity price decline were to reverse next year, how high would be the bar for the RBI to reverse its stance to meet its CPI targets?

The RBI rate cut is designed to provide a much needed boost to growth. But at the same time, this policy is also reminder of challenges faced by Indian economy especially in global context. Much needs to be done to ensure that we meet the country’s growth potential and people’s aspirations.

 

References:

  1. http://www.business-standard.com/article/finance/top-5-implications-of-rbi-s-50-bps-rate-cut-115092900265_1.html
  2. http://www.moneycontrol.com/news/economy/rbi-surprises-cuts-repo-rate-by-50-bps-keeps-crr-at-4_3306181.html
  3. http://www.cnbc.com/2015/09/29/india-rbi-cuts-key-rate-by-25bps-to-7.html
  4. http://www.financialexpress.com/article/economy/rbi-cuts-repo-rate-by-50-bps-in-monetary-policy-impact-on-economy/143745/
  5. http://www.business-standard.com/article/finance/top-5-implications-of-rbi-s-50-bps-rate-cut-115092900265_1.html
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Categories: Story Of The Week

1 reply »

  1. Nicely researched and written.!!
    Food for thought.. Cutting down repo rate by 50 basis points was immediately followed by 40 basis points cut in interest rates by SBI. However, other banks had cut down interest rates by around 25 basis points only on an average which is literally half of the rate cut implemented by RBI. Doesn’t this curtail the effect RBI is trying to impart by reducing the repo rate? Would cutting repo rate by 25 basis points twice in short interval of time be a more efficient way?