Lending rate reductions key to recovery

We expect the Reserve Bank of India (RBI) to cut the cash reserve ratio by 25 basis points (bps) to pull down lending rates to support growth on September 17. We do appreciate that Governor D Subbarao may not want to cut policy rates as inflation is still high. He would not like to take chances with RBI’s inflation fighting credentials. In any case, in our view, RBI rate cuts will not transmit into lending rate cuts until M3 (broadest money supply) growth normalises to 16 per cent from the current way-too-tight 13.7 per cent.

We also expect RBI to resume open market operations (OMO)–buying gilts to inject liquidity—by the end of September. While the money market deficit has eased seasonally, the structural liquidity deficit is rising.

 

Although RBI needs to inject about Rs 2 lakh crore of reserve money a year, the OMO of Rs 80,000 crore conducted so far has been virtually negated by the forward liabilities in foreign exchange of $14 billion (Rs 77,480 crore) contracted in parallel to defend the rupee. Slowing growth — we forecast 5.6 per cent in 2012-13 — surely makes a compelling case for easing liquidity. Although high lending rates are hurting loan demand, they are not coming off commensurately as tight structural liquidity is restricting deposit creation.

In fact, India is the only BRIC (Brazil, Russia, India and China) economy in which lending rates are running at their 2008 peak. Would lending rate cuts be enough if investment does not pick up?

We expect lending rate cuts to revive investment. After all, it was the sharp drop in lending rates after the dotcom bust that sparked off the subsequent jump in investment and growth in the early 2000s.

And, what about inflation? We urge RBI to switch gears to defend growth from fighting inflation, although we fancy ourselves uncompromising hawks. After all, the truth is that the battle against inflation is already won with core inflation slipping to five per cent levels. Although headline inflation will still rule high due to rain, oil and G-3 liquidity shocks, there is really little RBI can do about it. Besides, agflation should peak off with the revival of the monsoon.

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Indranil Sen Gupta is India economist at Bank of America Merrill Lynch