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Not by cuts alone

Repo rate cut will help lower borrowing costs, but growth revival will require a coordinated policy response.

Written by Saugata Bhattacharya |
Updated: August 8, 2019 3:56:09 am
repo rate, rbi repo rate, Monetary Policy Committee, repo rate mpc, mpc, policy repo rate, indian express, ideas page The RBI cut its FY20 India growth forecast from the earlier 7 per cent to 6.9 per cent with slight “downside risks”.

The Monetary Policy Committee (MPC) surprised us by cutting the policy repo rate by a higher than expected 0.35 percentage points, taking the policy repo rate down to 5.40 per cent, the fourth cut since February. The decision to cut the repo rate was unanimous, but two of the six MPC members voted to cut the rate by a lower 0.25 percentage points. The accommodative stance was retained.

There are three questions on the effect of the rate cuts. First, how much more room now exists for further rate cuts? Commentaries highlight the need to close the “output gap” — current activity being considered weaker than the economy’s potential. Addressing growth concerns “assumes the highest priority at this juncture,” it has been pointed out.

The global environment is partially responsible for this. The current theme is of synchronised rate cuts by central banks in both developed and emerging markets. Trade-related uncertainties, slowing investment and weak sentiment is resulting in a steady global growth deceleration and progressive weakening of sentiment, one reinforcing the other. Inflation has remained steady and low, and diffusing out from developed economies. Even some emerging markets are indicating that policy actions are now required to support not just growth, but also inflation. Other than the US Federal Reserve, Brazil cut its policy rate by a non-standard 0.5 percentage points, followed by New Zealand and the Bank of Thailand.

The RBI cut its FY20 India growth forecast from the earlier 7 per cent to 6.9 per cent with slight “downside risks”. The inflation forecast was kept more or less at the earlier level, averaging approximate 3.4-3.5 per cent for the year. Most monthly indicators of economic activity corroborate this, showing a deceleration across sectors. Capacity utilisation in the manufacturing segment in the January to March quarter of FY19, when seasonally adjusted, slipped from the earlier quarter. Early results of companies in the April-June quarter of FY20 show a slowdown in sales and profit growth. Of greater concern is a perceived weakness in both consumer and investment sentiment, with a changed perception of risk. For whatever reason, either employment uncertainty or a fall in disposable, discretionary incomes, consumption seems to be getting pushed back. MSMEs, an important job creation engine, have been adversely impacted by the loan squeeze from NBFCs — the second line of lenders which had increasingly become an important source of credit. MSMEs’ ability to absorb shocks seem to have shrunk, and this is also impacting supply chains in some sectors.

A set of signals of future expectations is provided by responses to surveys of businesses and households, conducted by the RBI and other independent organisations. While the RBI Business Assessment Index improved marginally, production and order books slowed. The Business Inflation Expectation Survey for June, conducted independently, reports that three-fourth of the respondents say that sales are “less than normal”. Given this growth-inflation trade-off, the current real repo rate (that is repo rate minus inflation) still looks relatively high.

The second issue is the transmission of MPC repo rate cuts to lending rates and, that is, operationalisation of the monetary policy signals into lower borrowing costs, particularly for households and small businesses. The cumulative rate cuts, together with durable liquidity infusion by the RBI through open market operations and foreign exchange swaps, has already led to a progressive reduction in banks’ benchmark lending rates (the MCLR) to which all bank loans — corporate, home, auto — are linked. This is likely to accelerate. Banking sector liquidity has been in surplus for the past month and funds for banks are likely to be less costly than in FY19.

However, adequate system liquidity in itself will not be enough to incentivise flows of funds to certain perceived vulnerable sectors of the economy, given risk perceptions and information asymmetry. The RBI and other regulators have initiated a series of measures to mitigate the credit squeeze, judiciously using relaxations of micro prudential norms to ease the bottlenecks. These include, among others, liquidity coverage ratio requirements, lower risk weights, exposure caps, asset securitisation restrictions, and liquidity backstops to the partial credit enhancement announced by the government. Gradually, these will get traction and is evident in the higher flow of bank credit to NBFCs in June.

The third aspect of the stimulus is the likely response of consumption and investment to the lower borrowing costs. The magnitude of this response will depend on the genesis and nature of the slowdown. While the proximate reasons are likely to be cyclical, influenced by the global economy, there are some underlying structural shifts. A combination of reforms and regulatory changes (actually much needed), overlaid with the effects of technological changes on consumer behaviour, seems to have adversely affected confidence. The median age of car buyers, for instance, seems to be rising. Rising sales of second-hand vehicles might be cannibalising new car sales.

If this hypothesis is correct (and certainly seems heuristically feasible), lower borrowing costs will have positive effects but are unlikely to provide a large boost to either consumption or investment. This means that reviving investor sentiment and thereby capital expenditure will require a broader, more coordinated approach to a stimulus package, combining fiscal, tax, industry, trade and other levers. Remedial measures have already been initiated by both the Centre and state governments. Sector specific impediment are being identified and sought to be mitigated. But it will take some time before their effects are evident.

The good news? Global environment will be conducive to India’s policy efforts, the expected continuing weakness in economic activity keeping metals and commodities prices moderate. Going forward, monetary policy will probably be data and event dependent, with stable inflation creating more space for the RBI for further rate cuts.

The writer is senior vice president, business and economic research, Axis Bank. Views are personal

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