Will rate cut by RBI help? Not really, says Morgan Stanley

There is a high probability that the Reserve Bank of India may cut benchmark interest rates when it reviews the monetary policy next week. Brokerage house Morgan Stanley belongs to the camp which feels lowering interest rates will not be effective enough to fix the problems of the economy.

“The more important question would be when the actual cost of borrowing in the banking system will come down,”  Morgan analysts Upasana Chachra and Chetan Ahya said in their report released today after the April index of industrial production numbers.

The Problem

A slowing economy, falling industrial output. GDP growth hit a 9-year low of 5.3% for the March quarter. IIP for April was a muted 0.1%.

And what Morgan Stanley thinks is the ……

…. The Cause

Policy makers’ decision to continue the bad mix of growth since the credit crisis is at the heart of most of the macro challenges facing the country. Supporting consumption (via fiscal expansion) while private investment (productive capacity addition) is slowing has been steadily taking down India’s potential growth over the last four years.

….The Solution

Monetary policy will be less effective in dealing with the effects of a stagflation-type environment. For an effective reduction in the cost of capital, the efficient cycle would be reduction in public expenditure (fiscal deficit) which helps to reduce consumption; increase savings and thus lowers the current account deficit and inflation pressures.

…But the reality

The government’s current policy stance will keep the fiscal deficit high and therefore the current account deficit and inflation will remain a challenge making it difficult to lower the short-term cost of capital meaningfully. We believe that this would lead to further deceleration in credit growth and investment growth.