Monetary policy review: PMC fallout adds to RBI's woes ahead of rate cut

India’s worsening banking problems are adding a new layer of complexity to the central bank’s monetary policy as it prepares to cut interest rates again to spur economic growth.

The Reserve Bank of India is set to lower its benchmark repurchase rate for a fifth time this year on Friday, days after it issued a statement to reassure the public that the banking system is “safe and stable.” It recently imposed withdrawal curbs on a small bank and lending restrictions on another lender.

The latest trouble in the banking system may further hurt lending in an industry still grappling with the fallout from the collapse of a major shadow lender last year. That’s had a knock-on effect on consumption and investment in the economy, pulling down economic growth to a six-year low.

“Nerves are fraying, speculation is rife and the last thing India needs right now is a run on banks,” said Arvind Chari, head of fixed income & alternatives at Quantum Advisors Ltd. in Mumbai. “They need to soothe the frayed nerves and quell unnecessary speculation to impart confidence into the financial system.”​

​All 31 economists surveyed by Bloomberg see a rate cut this week, though the magnitude differs from 20 basis points to 40 basis points. The RBI’s unconventional 35-point cut at its last meeting has made it more difficult for analysts to predict moves.

Governor Shaktikanta Das has made it clear that spurring growth is his priority. He recently signaled his willingness to continue easing monetary policy, given stable and below-target inflation.​

Growth slowed to 5% in the quarter to June, the weakest since March 2013, and leading indicators suggest there are few signs of a recovery. That may prompt the RBI to revisit its full-year growth forecast of 6.9%.

​The RBI’s likely rate cut this week comes on the back of several fiscal steps announced by the government recently to spur growth, including a surprise $20 billion reduction in corporate taxes.

But the fiscal boost probably won’t be enough, putting the RBI under pressure to cut rates further. Pranjul Bhandari, chief India economist at HSBC Holdings Plc. in Mumbai, estimates the nation had an output gap -- the difference between actual and potential output -- of 0.7% in the quarter ended June. A fiscal stimulus of 0.5% of GDP is insufficient to close such a large gap, and an additional 50 basis points of rate cuts would be needed, she said.

Economists say the fiscal stimulus is unlikely to fuel inflation, and since the government hasn’t increased its borrowing plans for this year, there’s adequate policy space for the RBI to continue cutting rates for now.

“The fiscal stimulus is unlikely to cause inflationary pressures,” said Shubhada Rao, chief economist at Yes Bank Ltd, who expects a 40 basis-point cut this week. “This is the time to support growth and front-loading the rate cut will aid that process.”