RBI on ‘lower for longer’ rate track, must unclog funds flow

Sachchidanand Shukla

The fact that there will be a rate cut from the Reserve Bank of India (RBI) for the fifth consecutive time this year was a given. The question most seemed asking was whether it will be the conventional 25 bps cut or another unconventional 35-40 bps. The RBI did not disappoint really, with a 25 bps cut in the repo rate.

The key question post the government’s big fiscal move in the form of corporate tax rate cuts, 135 bps cumulative rate reduction and higher liquidity is whether one should temper their expectations of the terminal repo rate. Interestingly, the central bank has answered that in somewhat Draghi-esque way. Sample this – It said “the MPC also decided to continue with an accommodative stance as long as it is necessary to revive growth".

The RBI had enough justification for further accommodation and the above stance. The reasons are not difficult to see.

Growth outlook:  What stands out in the policy is the sharp cuts in growth projections. The central bank cut its GDP growth outlook for FY20 to 6.1 percent from 6.9 percent in the previous meeting. The cut is much sharper than market estimates at ~6.3-6.5 percent. Projections for full-year FY20 have also been revised in each of the past four meetings -- to 6.9 percent in August 2019 from 7.4 percent in February.

The RBI has slashed growth projections by 130 bps to 5.3 percent for Q2 and to 6.6-7.2 percent for H2 from 7.3-7.5 percent earlier. Importantly, the RBI has introduced FY21 growth estimate at 7 percent, which in itself is an acknowledgement of growth recovery being much more gradual and more ‘U’ shaped than ‘V’.

Inflation: The apex bank has revised inflation projections for Q2 FY19 upwards to 3.4 percent, from 3.1 percent earlier. It has however, maintained projections for H2 at 3.5-3.7 percent. For FY21, the RBI has projected inflation rate of 4 percent.  It assesses risks around inflation to remain balanced, with comfort around food inflation owing to healthy kharif output and weak demand conditions being offset by volatile oil prices and currencies and a rise in 3-month and 1-year ahead inflation expectations.

Real rates: Even after the latest 25 bps cut, the real policy rate (using the repo) stands at ~1.15 percent assuming an expected inflation of 4 percent in the next 12 months. The RBI had previously espoused a real interest rate of ~1.25-1.5 percent while highlighting that it was a time-varying concept.

Fiscal measure time lags: We also need to bear in mind that corporate tax cuts can leave some cash behind in corporate balance sheets through higher profits which in turn can be used for capex, deleveraging or for providing higher discounts on their offerings. But in all likelihood and given the state of demand and corporate balance sheets, it will go into deleveraging or conservation of capital for another day.

Monetary transmission: Monetary transmission has remained muted so far. While the RBI cut rates by 110 bps between February and August 2019, the weighted average lending rate (WALR) on fresh rupee loans decreased by just 29 bps. The WALR on outstanding rupee loans actually increased by 7 bps during the period!

Unclogging the funds flow mechanism: External benchmarking of lending rates (implemented from October 1) should address the issue of faster transmission and aid the lowering of lending rates. However, lower lending rates would take care of a part of the problem.

The key issue is the clogging of the funds flow in the economy. According to the RBI’s latest Monetary Policy Report, the flow of funds to the commercial sector has slumped to just Rs 91,000 crore during April to mid-September this fiscal, from Rs 7.4 lakh crore in the year-ago period. This is explained by sharp decline in funding by banks, NBFCs and HFCs. These three, together, account for nearly 84 percent of the decline in the flow of funds to the commercial sector. It is important that the RBI quickly addresses this issue by stepping in to infuse confidence where necessary and unclogging the system.

Going forward, given the benign inflation outlook, muted growth forecasts and the extremely dovish statements by the RBI, there is room to cut rates further despite fears of fiscal slippage. We also believe that the RBI may stay “lower for longer”, given its growth-inflation assessment for FY21 i.e. 7 percent GDP growth and 4 percent inflation.

Sachchidanand Shukla is chief economist, M&M Group. Views are personal.