Lowering rates may not really lead to the push required for growth

With the monetary policy committee (MPC) already indicating in the last two policies that inflation would not be the only factor that would drive the decision on interest rate changes, it is not really a surprise that the Reserve Bank of India (RBI) has gone in for a rate cut, especially after rather disappointing numbers have come out on GDP (gross domestic product) growth in Q4 and unemployment rate. The extent of rate cut was debatable – and settling for 25 basis points (bps) would be something that the market has buffered in. The important question is whether or not this will work?

From the monetary standpoint, a rate cut helps companies and individuals that borrow as it lowers cost of loans provided banks pass it on. Banks would be in a position to lower lending rates in case they can lower the deposit rates. This may not always be feasible, given that growth in deposits has tended to lag that in credit, which had created a virtually permanent liquidity deficit. This, however, has been plugged through the liquidity adjustment facility (LAF), open market operations (OMO) and forex swaps.

Globally, central banks have been seen to be the driving force behind growth when interest rates are lowered as it gets investment going. This is less obtrusive than fiscal stimulus, which has a bearing on the fiscal deficit. A cut in repo sends strong signals to the market that has to, in turn, pick-up the cues. Therefore, the transmission is important. Contrary to the often expressed view that is critical of the transmission mechanism, it has been observed from RBI data on weighted average lending rates (WALR) on new loans has actually moved in consonance with the repo rate. This means that the benefits are flowing to the customer.

It is a different issue that borrowers have to borrow more for investment. If they do not borrow more but take advantage of the lower cost, it helps their profit & loss (P & L), but may not add anything to investment, which appears to be the case today. The problem is more on the demand side. Hence, lowering rates may not really lead to the push required for growth. Consumption has not quite picked up pace, which has also meant that the capacity utilisation rates have not reached the level required for that extra push. Infra investment remains stagnant from the private sector; and the NPA issue combined with the NBFC (non-bank finance companies) challenges has to be sorted out before there is fresh interest shown.

But such a rate cut can have wider ramifications for savings, as presently the problem is also on this front where households are saving less. Also, as there is a significant part of the population that lives on interest income, there could be negative effects on such spending that hence comes back to hurt consumption. This is one reason as to why banks have not been lowering their deposit rates with alacrity.

The accommodative stance indicates that there will be further easing of inflation, which also means that the monsoon will not be perverse nor are there any known fears of fiscal led demand-pull inflation forces. Therefore, inflation will remain benign under 4 per cent and we can expect another 25-50 bps cut in the repo rate during the year.

Interestingly, this also means that the RBI does not see the economy picking up as it has lowered its forecast to 7 per cent from 7.2 per cent. The 0.2 per cent number is not significant but a lower revision means that we may not be seeing too many green shoots this year. It will be another tough year for the economy and the employment-output equation may not change much.

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Madan Sabnavis is chief economist at CARE Ratings. Views are personal