For the rate cut to be effective, there needs to be monetary policy transmission by the banks.
The Reserve Bank of India (RBI) has cut the policy interest rate by 25 basis points (bps), making it the second rate cut in 2019. With the global growth concerns and taking a cue from the pause by US Federal Reserve, many Asian economies including Indonesia, Philippines have put their interest rates decision on hold in 2019 following aggressive rate hikes till last year. But, RBI has taken the lead and has cut rates twice in the current year. At 6 percent repo rate and inflation of 2.6 percent, the real rate of interest in India is still at a high at 3.4 percent compared to an average of 2.3 percent in 2018.
RBI has been following flexible inflation targeting, with an inflation target of 4 percent (upper ceiling of 6 percent and lower limit 2 percent). With inflation estimated to remain below 4 percent in 2019, RBI is focussing on the domestic growth concerns. Global growth slowdown has further bolstered RBI’s rate cut decision.
While the RBI has cut the repo rate, the critical aspect is monetary policy transmission by banks. The last policy interest rate cut by RBI in February was not fully passed on by banks in terms of equivalent reduction in lending rates. Banks base their lending rate on MCLR (marginal cost of lending rate), and given the high cost of capital, they were unable to pass on the rate cut. In the last few months, the bank’s credit growth has picked up to 14-15 percent, but deposit growth has remained at a low of 10 percent. This has resulted in banks credit/deposit rate rising to a precarious level of 78. This makes it difficult for banks to cut interest rates on the asset and liability side. Bank deposit also faces competition from Government’s small saving schemes (giving higher interest rates) making it further difficult for banks to pass on the rate cuts.
Market interest rates have also not responded much to the RBI rate cuts. In the last two months, the yield on the benchmark 10-year government security has broadly been in the range of 7.30-7.40 percent. The fixed income market is concerned about the high supply of government securities in the current fiscal year. Central Government has budgeted a net borrowing of Rs 4.7 trillion for this fiscal year. On top of this, there will be a supply of state government bonds and CPSE (Central Public Sector Enterprises) borrowings. Government fiscal deficit (centre+state+off-budget) is estimated to be around 8 percent of GDP.
In fact, there is a risk of fiscal deficit slipping further, going by the GST collection trend, chances of farm loan waivers and other doles being promised by the political parties in the run-up to the election. Hence, even with inflation remaining benign and RBI cutting policy interest rates, market interest rates have not fallen.
The other important aspect is if marginally lower interest rates will be able to spur investment in the economy. Investment GDP is estimated to have jumped by 10 percent in FY19. Other investment indicators like cement and steel production have also been recording good growth. So far, the investment pick-up was being mainly led by the government. But with fiscal pressure increasing, the government capex could take a hit. As per the interim budget, the Government capex/GDP ratio is budgeted to fall to 4.5 percent in FY20 from 5.1 percent in FY19. The CPSE capex plan for FY20 as based on IEBR (Internal and extra-budgetary resources) also does not look impressive.
As far as the private sector is concerned, stressed assets remain a concern. Overall bank credit growth has jumped up to double-digits. Credit offtake by industrial sector has also improved to 5 percent from a low growth of 1 percent a year back. Credit demand and investment by the private sector could see a pick-up as capacity utilisation level has improved to 75.9 percent (higher than the long-term average). While the bank credit supply could see some improvement with many PSBs (Public Sector Banks) coming out of the PCA (Prompt Corrective Action), liquidity crunch for the NBFC sector and the subsequent sharp reduction in disbursement is a grave concern.
The cut in the policy interest rate is a welcome step at a time when the domestic economy needs a policy boost. Globally, most Central Banks are also moving towards neutral or accommodative monetary policy stance. However, for the rate cut to be effective, there needs to be monetary policy transmission by the banks. More importantly, while RBI has cut interest rate, it will be critical for the Government to correct some of the other bottlenecks for investment and overall growth to pick-up.Rajani Sinha is corporate economist based in Mumbai.