Rate cut essential to spur both investment and consumption

The US Federal Reserve Board has cut interest rates thrice in the last three months. “The US is on the precipice of its first consumer recession since 1991, which was the last time the market suffered from a confluence of high energy prices, weakening employment conditions, real estate deflation and tightening credit,” explained Merrill Lynch economist David Rosenberg. He opined that the Fed would need to cut interest rates to 2 per cent by mid-2009 to sustain the recovery.

“Interest rates will go down. In fact, they have started showing signs of going down. There will be another fall in April. Interest rates across the world are influenced by the US scenario… and US rates are coming down. The whole economy will benefit from the fall in rates in India… consumption will increase,” pointed out Standard Chartered Bank MD Prakash Subramanian.

Bankers expect interest rates to ease by 25 to 50 basis points (bps), probably in two months or so. However, the RBI has not given any signal of a reduction in rates so far. Lending rates have risen by over 50 per cent over the last three years, thanks to the high growth in credit offtake in a booming economy.

For example, home loan rates soared from around 7.5 per cent to 10.5-11 per cent during this period. Ditto is the case for consumer and auto loans. The high rates have led to a decline in demand in several sectors.

In April-September, the consumer durables sector showed a decline of 1.3 per cent, compared to a healthy 12.7 per cent growth in the corresponding period last year. A series of interest rate hikes over the past year has slowed down the demand for automobiles, real estate and some consumer durables.

Two-wheeler companies have been the worst hit with sales falling by 4 per cent, the first fall in the last five-six years. If interest rates fall, consumption is expected to rise.

There may, however, be problems in sectors like real estate, which may witness another price spiral after the fall in interests. On the other hand, housing loan growth declined from 38.3.per cent in 2005-06 to 24.6 per cent in 2006-07. “The regulator will tackle all that,” said Subramanian.

RBI Governor Y V Reddy, too, has admitted the softening trend in interest rates in many countries. “Liquidity is being provided by leading central banks in ample measure, at relatively softer terms, for longer durations than ever before. Despite the prevailing assessments on inflationary pressures, the concerned central banks are perhaps indicating softer interest-rate regimes, thus inciting fears of stagflation,” he said last week.

Reddy, however, had commented recently that US Fed rates are a relevant but not determining factor for deciding the country’s monetary policy. Loans and advances of commercial banks registered a robust growth of 30.6 per cent in 2006-07, on top of the high growth 31.8 per cent in 2005-06 and 33.2 per cent in 2004-05.

Among the major components of bank credit, term loans — which constituted the major component of loans and advances portfolio — continued to grow at a strong pace (34.9 per cent) during the year, according to the RBI. This high growth has now dropped, with credit growth at 22.2 per cent and deposit growth at 23.9 per cent as on December 7, 2007.

Going by the plans of India Inc to raise funds from the capital market, corporate investment in new projects is growing like never before. “Demand for funds will continue. A fall in rates will boost investment in new projects. Thousands of small units are now finding the high rates a major hurdle in their growth plans. They will benefit from a cut,” observed an official with a private bank.

Borrowers will, however, have to wait for some time before they can access cheaper bank funds. The Reserve Bank of India credit policy, due in the last week of January, may turn out to be the catalyst for a rate cut.

WHY NOW?

• Inflation has fallen to a five-year low of 3.5%

• Banks are sitting on comfortable liquidity

• US Fed has slashed rates thrice in the last three months

• Some sectors like automobiles and consumer durables are facing a slowdown

• Huge capital inflows and burgeoning forex reserves