Over 10 days ago, RBI Governor Raghuram Rajan was counselling India’s industry to be patient, saying the country should resist quick fixes. He cited the turmoil witnessed in Brazil, an emerging market peer, after their central bank was pressured to reduce interest rates in a bid to grow fast, leading to a credit spree.
But on Tuesday, India’s central bank chief delivered a major surprise, cutting the key policy rate — the repo rate — by half a per cent, or 50 basis points, to 6.75 per cent when the consensus was that the cut would be by just 25 basis points as has been the case thrice this year so far.
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RBI Governor Raghuram Rajan on being asked if his views on inflation are ‘Hawkish’. pic.twitter.com/D2C2bFwC9J
— ANI (@ANI_news) September 29, 2015
Despite pressure from many quarters for a deep cut, the RBI had so far preferred a baby-step approach — of lowering rates in small doses. But this time, with prospects looking bleak of global growth rebounding, emerging markets such as Brazil, Russia and South Africa in trouble, and the continuing under-utilisation of domestic capacity, the RBI has provided a monetary stimulus aimed at aiding economic recovery.
With demand conditions still sluggish, as reflected in the slack in factory output with average capacity utilisation of a little over 70 per cent, and with inflation (wholesale and retail) falling faster than the bank’s projection of 6 per cent by early January 2016, the RBI opted to go in for a deeper cut or what it calls “frontloading”.
A higher cut may also well have been influenced by the RBI’s reading of growth prospects this fiscal compared to the Government’s hopes of a growth rate in the range of 7.5-8 per cent. The RBI reckons that it could be lower, cutting its growth forecast to 7.4 from 7.6 per cent earlier with inflation also expected to slide faster than earlier estimates.
Indeed, looking at the monetary policy review statement, the RBI appears far more concerned about growth. With limited elbow room for the Government to provide any support, it is the central bank that has stepped in. The Government may appear justified now, given the arguments it had marshalled in favour of a deep rate cut for quite a while. Both Finance Minister Arun Jaitley and his predecessor P Chidambaram were quick to welcome this cut.
However, this is expected to be the last rate cut of the year, and the onus will now clearly shift to the Government to keep its side of the bargain — in terms of prudence to meet the targeted fiscal deficit of 3.9 per cent in 2015-16, and to further ease rules and unveil policies to boost investment and growth.
Where the 50 basis points cut today has also helped is in forcing banks to react quickly, unlike the last few rounds where Indian lenders were loath to reduce rates citing technical issues of transmission or difficulties in cutting deposit rates, and with a huge pile of bad loans to be taken care of.
India’s largest bank, State Bank of India, was quick off the block lowering rates by 40 basis points, which should see others follow suit soon. Though RBI has cut rates by 75 points so far this year, it has translated into an average lending rate cut by banks of only 30 basis points which has frustrated both the central bank and the Government.
Rajan appears to have got the timing right though, coming as it does with the feel-good factor generated by Prime Minister Narendra Modi’s US trip and a few policy pronouncements made recently by the Government including on tax policies and the US Federal Reserve holding its hand on raising interest rates.
What Rajan may also have got right is in reversing course, unlike his predecessor, D Subbarao, who was criticised for his baby-step approach. In hindsight, many reckon that Subbarao may have erred in not raising interest rates aggressively when inflation was in double digits. It has also helped Rajan that global commodity prices continue to remain low.
The former IMF chief economist and professor at Chicago University said there is always pressure, “threats” and pleas for rate cuts but what counts for him are policies which are “sustainable and can foster enduring growth”.
“Everybody and his cousin have a theory on how to run the economy,” said Rajan. He went on to quickly dismiss suggestions that he is a “Santa Claus” with the comment that may well be quoted often in the future: “The name is Raghuram Rajan, I do what I do.”
Going ahead, it appears imminent that with today’s rate cut action, interest rates on small savings schemes and the Public Provident Fund, and that on provident fund and retirement schemes averaging way above 8 per cent will come down soon. The RBI and the government will discuss this soon.
That may be disappointing to savers but with effective real interest at above 3 per cent it may be a negative for other segments. Rajan has often said in the past that an effective real rate could be in the band of 1.5-2 per cent to incentivise both savers and borrowers.
The rate cut apart, Rajan did announce a few policy measures which are bound to have a positive impact in the medium term. By allowing foreign investors to buy more Indian government bonds, he could help create a new set of investors for these securities, besides ensuring that rates remain stable.
It is in keeping with the flavour of this government that new rupee bonds which Indian companies can float overseas have been called as “masala bonds”. These bonds will shift the risk of currency for Indian issuers to foreign investors and in the long run lead to a growing internalisation of the Indian currency.
The 50 basis point cut will also mean that banks could be in a position to book treasury gains on the bonds they hold. In the past, at a time of downturn, banks had used such gains to set aside more money to provision against their bad loans.
One of the measures announced by the RBI today could signal a major change in the way companies access credit in the medium term. The plan is to nudge large corporates with borrowings from banks above a cut-off level to tap the market to raise working capital and term loans. This should free banks and enable them to lend more to small and medium sized business and for infrastructure projects. If that happens, it will have a knock-on impact on India’s corporate bond market, which successive governments have sought to promote for over three decades. This goes with some of the steps which the RBI has taken over the last year or two to change the way promoters have milked companies. Banks now have the support of the central bank when it comes to acting tough against errant promoters.
And with a roadmap for reducing the Statutory Liquidity ratio, or SLR, or the mandatory level of bonds which they have to hold by one per cent in a year, banks will be in a position to lend more.
C Rangarajan, the former RBI governor who Rajan had quoted in the past for his inflation-fighting stance, said that if warranted, inflation-targeting will get discarded when things are not going in the right direction. “When you are not sure what will happen, it is best to frontload rate cut action,” he said.