3 reasons why rate cut is better for India right now

Brokerage house Bank of America Merrill Lynch has joined ranks with the camp calling for a rate cut by the RBI. BoAML expects a dovish monetary policy in December, but sees the first rate cut only in February.

India's repo rate or the rate at which banks borrow from the RBI is currently 8 percent and the cash reserve requirement of banks at 4 percent.

Claiming itself to be a relentless hawk, this firm argues that lower cost of capital will give a fillip to the Indian economy.

"First, the incentive to invest will surely ultimately depend on visibility of rising demand that will come with lower rates. Although a lot is made about how the 2003-2007 upcycle was driven by rising investment, it should not be forgotten that this itself resulted from Governor Jalan's sustained easing," BoAML's India economist Indranil Sen Gupta said in his report.BofAML expects the country's gross domestic product (GDP) to grow at 6.5 percent in FY16, but this optimism hingcritically hinges on 50-75 basis points of lending rate cuts.

"Given that we have already entered the October- March busy season, it is unlikely that banks will be able to cut rates before April. As rate cuts typically take about 6 months to have effect, it will support growth only in 2H2015," the BoAML report said.

Three reasons, according to Sen Gupta, which a rate cut will boost economic growth:(Excerpts from the report)

It is critical to understand that investment has slowed down, not only in India, but all over the world. While the earlier "policy paralysis" in Delhi may have stalled infrastructure projects, the fact is that the global downturn has dampened the incentive to expand capacity. Against this backdrop, we do not see any recovery in the capex cycle in 1H15 unless rates come off to support domestic demand.

We are a long, long way away, in our view, from the situation of growth pushing up inflation. FY15 growth, at 5.5 percent, is well below our estimated 7.5 percent potential In fact, the RBI's own freshly-minted inflation model shows that a 100bp increase in growth will fuel only 20 basis points of CPI inflation given the slack in the economy.

High rates are proving a disincentive to produce and invest. While the consumerfaces CPI inflation, the producer's pricing power is better measured by non-food manufacturing WPI inflation. On ex-post basis, real lending rates, at 12.5 percent, are at historical highs relative to average of 8.8 percent since 1997. This is clearly hurting economic recovery.