Reserve Bank of India governor Duvvuri Subbarao on Tuesday surprised the market with a sharp 50-basis point (bp) reduction in the repo rate to boost economic growth, but warned there was limited scope for further cuts.
The first rate cut in three years cheered investors and companies, with bond yields and swap rates falling sharply and stocks extending gains, although the rally was capped by expectations there would be few further cuts, at least in the near term.
What kept the cheer muted was the cautious tone in the monetary policy statement. “It must be emphasised that the deviation of growth from its trend is modest. At the same time, upside risks to inflation persist. These considerations inherently limit the space for further reduction in policy rates,” Subbarao said, adding that going forward, the policy stance would change based on the growth-inflation dynamics.
The RBI also said, “The economy is likely to revert close to its post-crisis trend in FY13, which does not leave much room for monetary policy easing without aggravating inflation risks.” Subbarao said the higher-than-expected rate cut was to send out a stronger signal for “adjustment” in bank deposit and lending rates.
Bankers were quick to take the cue. State Bank of India chairman Pratip Chaudhuri said the reduction of costs would be passed on to customers. “We would do a comprehensive cut in lending rates,” said Chaudhuri. He, however, added the rate cut might not happen across the board but only in segments where the mark-up on the base rate was significantly high. The bank’s board is meeting this evening to take a call.
HDFC Bank MD Aditya Puri said interest rates — both deposit and lending — would definitely come down, but would probably take a while because banks could bring lending rates down only when the cost came down. A research note by the bank said it expected rate cuts of close to 25 bps only by the end of the first quarter of FY13, as some moderation in credit demand in the slack season was expected to ease pressure on the system.
Most experts said the prospects for further policy rate cuts were not bright.
Nomura economists Sonal Varma and Aman Mohunta said, “We expect both headline and core inflation to inch higher in April due to the hike in indirect taxes and adverse base effects. As such, we expect RBI to remain on hold in June and most likely in July. On balance, we expect only one more repo rate cut of 25 bps in 2012.”
India Inc was, however, relieved with what it got. Essar Group CFO V Ashok said the beginning of a trend reversal would at least improve the sentiment. Confederation of Indian Industries said the repo rate cut would provide a boost to investment as well as send a strong signal that turning around growth was of pivotal importance. The decision to cut rate, according to the central bank, was driven by the fact that growth had fallen below the post-crisis trend and the fall in inflation, especially core inflation, though volatility in oil prices due to geopolitical tension may exert pressure on inflation.
The RBI left unchanged the cash reserve ratio (CRR), the share of deposits that banks must hold with the central bank, at 4.75 per cent, in line with expectations. The ratio had been cut 125 basis points since January to ease tight market liquidity. Subbarao said liquidity conditions were moving towards normal after several months of acute shortages of cash in the banking system, but also said the RBI would take “appropriate and proactive” steps if needed to restore liquidity to comfortable levels.
The central bank said its baseline expectation for gross domestic product growth in the fiscal year that would end in March 2013 was 7.3 per cent, compared with an expected 6.9 per cent in the just-completed year. It expects headline inflation to end the year at 6.5 per cent, with little deviation expected during the year.
Sluggish capital investment has exacerbated bottlenecks in the Indian economy, bringing down its capacity for non-inflationary growth to an estimated seven per cent, from 8.5 per cent before the global financial crisis. The announcement came with a thinly veiled warning to the government that more progress was needed on fiscal policy and reform. Subbarao reiterated the need for the government to cap its subsidy burden, which led to a bloating of the fiscal deficit in the recent fiscal year to 5.9 per cent of GDP. “It is imperative for macroeconomic stability that administered prices of petroleum products are increased to reflect their true costs of production,” Subbarao said.
Reacting to the higher-than-expected rate cut, the yield on the 10-year benchmark government bond dipped to 8.22 per cent from the opening level of 8.51 per cent. The yield closed at 8.34 per cent on Tuesday, 11 bps lower than the previous close.
The rates on certificates of deposit (CDs) that had touched three-year highs of 11.75 per cent in March had softened to 10 per cent on relatively better liquidity conditions this week. On Tuesday, the rates on three-month CDs fell further to 9.45 per cent. “The rate cut of 50 bps was a positive surprise for the markets. We can expect rates to soften further,” said Ajay Manglunia, senior vice-president, Edelweiss Securities.
The overnight call rates also eased to 8.3 per cent from the opening levels of 8.9 per cent and closed at 8.5 per cent on Tuesday. Banks borrowed Rs 80,500 crore from the central bank’s repo window. The Bombay Stock Exchange benchmark, Sensex, traded almost flat in early trade ahead of the RBI monetary policy. The 30-stock index briefly rose nearly 200 points after the rate cut announcement, but gave up half of those gains as the central bank’s cautious outlook on further rate cuts tempered enthusiasm. The markets started to climb back again around 2 pm after major European markets rallied and the Sensex ended up 1.21 per cent, or 206.99 points.