The Reserve Bank of India on Thursday cut its benchmark rate by 25 basis points to 7.75 per cent, surprising the market with its timing as it signalled the start of the next cycle of lower interest rates, which will have a knock-on impact on business and overall sentiment, with cheaper cost of borrowing for companies and consumers, and help revive business over the next fiscal after two consecutive years of sub-5 per cent growth.
Both corporates and the government had been pitching aggressively for cutting interest rates, saying that the cost of capital was still high and was a major hurdle to reviving business. The decision to cut rates well ahead of the next policy review in early February may have stumped companies and bankers, but with inflation easing way below the RBI’s original projections of 6 per cent by the start of 2016, and with global oil prices sliding further, the RBI decided to go ahead with a rate cut.
The government’s commitment to stick to the fiscal deficit target of 4.1 per cent of GDP for 2014-15 was another factor which influenced this decision. The RBI had raised rates starting from July 2013 as inflation topped double digits before a pullback last year, paving the way for a cut now.
What will really boost sentiment is the signal that more rate cuts are in the offing — a cue which the markets picked up as stocks surged with the benchmark Sensex up by 728.73 points while the ten year bond yield slid to 7.69 per cent, a level last seen close to 18 months ago. There are many who are now betting that the next rate cut could be as close as this year’s Budget or shortly after that, depending on the fiscal consolidation plan which the finance minister is expected to unveil then.
Analysts are expecting the interest rate to be cut by 75 basis points during the course of this year or perhaps next fiscal provided there aren’t any major shocks — on the global commodity prices and geo-political front. The RBI too is hoping that there aren’t any such shocks down the road as it starts lowering rates progressively.
RBI Governor Raghuram Rajan had said even after the last review in December that the central bank wanted to be certain that inflation expectations were dampened so that when it starts cutting rates, it would be a consistent trend for a good stretch of time, instead of being forced to back-pedal halfway. It helped that crude oil prices fell so sharply through this fiscal that the gain in terms of lower imports could be as high as $50 billion. The gain from this, which could feed into the broader economy, is expected to be 1-1.5 per cent of GDP, which should mean a higher economic growth in 2015-16. The RBI’s growth estimate for 2014-15 is 5.5 per cent.
Banks started cutting their lending rates, led by United Bank of India which lowered its base rate or minimum lending rate to 10 per cent. Deposit rates, which are now positive with consumer price inflation at 5 per cent in December, will moderate after years of negative return with high inflation eroding returns in real terms.
For corporates and consumers, the benefit of a lower rate will only be on fresh borrowings. The impact of this will be felt only over the next few months, especially for debt-laden infrastructure companies. In the near term, banks will gain as lower rates will translate into gains on the bonds which they hold on their books, bought at higher rates.
The stock market may be bullish on banks now but a clean-up of the huge pile of bad loans aggregating 2,69,000 crore and stressed asets which lenders have accumulated over the last few years will take time as growth is yet to pick up. Loan growth has also been at a low — a tad below 6 per cent for April-December 2014 — a reflection of the current slowdown with demand yet to pick up.
With the signalling of a low-interest regime, structural changes in terms of governance in state-owned banks which control a large part of assets in India’s banking sector and de-leveraging of corporate balance sheets or cleaning up debt could help put building blocks in place for the next wave of economic growth.
Unlike the last time in the late-’90s and the period up to 2002, when huge cuts in rates helped banks address the issue of bad loans, it could be an uphill task this time, given the scale of bad loans — contracted during the high-growth years dating back to the UPA regime. What will make it tough for banks is the fact that top companies and good quality firms are raising funds through foreign borrowings at relatively lower rates. But a positive for corporates is a surging stock market which will help boost valuations and the promise of robust inflows like last year. For the central government and states too, this will translate into lower borrowing costs while consumer companies are hoping that spending will now pick up.
On Thursday, Rajan indicated that the key to further easing or lowering of rates would be data which confirms continuing disinflationary pressures. He also gave enough indications that crucial to keeping the lower interest rate cycle going would be the Union Budget in February, coupled with economic reforms.
“Also critical would be sustained high-quality fiscal consolidation as well as steps to overcome supply constraints and assure availability of key inputs such as power, land, minerals and infrastructure,” Rajan said. India has stalled projects worth Rs 18 lakh crore which need to be revived. Former RBI Governor C Rangarajan said that with inflation well below RBI’s projections, a cut was indeed on the cards. But critical to sustaining the momentum generated by lower rates will be liquidity, he said, adding that the RBI will have to support by providing the required liquidity.
The rate cut was welcomed by the government as well as bankers. Finance Minister Arun Jaitley said this could kickstart the investment cycle. “Together with the various initiatives being taken by the government, the rate cut would strengthen the positive momentum in the economy by lowering borrowing costs as the lower rate regime reflects in bank funding costs over time,” said Chanda Kochhar, MD & CEO, ICICI Bank.
Banks have already started reducing the rate of interest on deposits, which will eventually bring down the cost of funds, prompting them to cut lending rates. “With global crude and commodity prices expected to be benign, inflationary expectations moderating to single digit, the current disinflationary impetus is likely to be firmly entrenched and unwinding. We thus believe that this cut may be just the beginning of a rate easing cycle,” said Arundhati Bhattacharya, Chairman, State Bank of India.
For borrowers, who have been patiently waiting for a reversal in interest rate cycle, the coming months would see a decline in their equated monthly installments (EMI) on their home, vehicle and personal loans. How soon the RBI cut will be transmitted down the line is something that even the RBI is concerned about. While the elevated credit cost for banks and the poor track record of banks in transmission of rate cuts are concerns, corporates and industry chambers like CII are hopeful that the pass-through benefit of repo rate reduction will come soon.