Updated: December 26, 2015 12:10:07 am
RBI Governor Raghuram Rajan sprang a surprise on Tuesday by reducing the benchmark repo rate by 50 basis points (bps) — twice what was expected. The move paves the way for the banking system to lower interest rates, which, in turn, would lead to cheaper retail loans for homes and cars, etc. More importantly, it is expected to spur investment activity in the domestic economy. Recently, almost all economic data pointed towards the need for a rate cut. Global demand has plummeted, with Indian exports registering nine straight months of decline. Domestic economic recovery is still tentative, with inventories piling up in the face of weak demand. Credit growth fell to a 20-year-low in June, and yet the banking system is saddled with growing bad loans, thanks to persistent policy logjams, delayed clearance of projects and aggressive expansion by the corporate sector since 2011-12. For an investor, it is a paralysing scenario. However, the inflation rate has moderated to the RBI’s liking, and it appears Rajan is now willing to do his bit to induce investment at a time when the other engines of growth are sputtering. The focus must now shift to the transmission of these cuts to the intended beneficiaries.
Before the cut on Tuesday, the RBI had reduced repo rates by 75 bps since January. However, the pass-through by banks to customers was only 30 bps, on an average. With the latest cut, that differential stands at 125 bps. In fact, the current gap between the repo rate and the bank rate is 300 bps. In other words, a loan seeker has to pay 3 per cent more than what the RBI signals. In the past, banks have blamed the high interest rates paid by the government on short-term saving schemes like the public provident fund, or post office deposits. But the real reason for the inefficient pass-through is that banks must constantly allocate more funds to counter the growing NPAs. To boost transmission and push banks to aggressively cut interest rates, the finance ministry has announced that it would review the interest it pays on small savings.
The NDA government has signalled that it would push for investment-led growth as against the UPA’s consumption-led model. However, high interest rates, deeply stressed banks and an over-leveraged corporate sector make that strategy a non-starter. This cut could help break the negative cycle. But the government must ensure that two key conditions are met. One, no fiscal slippage that could renew the inflationary spiral and lead to high interest rates. Two, speeding up of reforms that make it easy for people to invest and do business.
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