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Posted by: Deepa Vasudevan on Fri, Apr 12th, 2019

RBI Monetary Policy: A Rate Cut for a Recovery

A complete business cycle has four stages- boom, slowdown, recession and recovery. The recovery phase is characterized by rising but below-trend growth, and low inflation. If nurtured carefully, a recovery could evolve into a boom. The current state of the Indian economy is best described as a hesitant recovery. Real growth at 7% in FY19 and 7.2% in FY20 are below trend. Capacity utilisation increased to 75.9% in Q3FY19, but is still some distance from the 80% number that typically signals fresh investments. Headline CPI inflation averaged 3.5% in FY19; it is projected to be below 4% throughout 2019.

This is the classic recovery scenario of subdued inflation and rising growth. And RBI has brought out the classic solution- cut interest rates, ensure adequate liquidity and ease norms to increase lendable funds of banks. The hope is that a lower cost of funds will incentivize consumers and corporates to borrow more, and the resulting demand push will boost economic growth.  However, this outcome faces two obstacles: poor monetary transmission and uncertainty about future policy direction.   

Ineffective transmission has always been the bottleneck of India’s monetary policy. The policy repo rate has been cut by 50 bps since the start of 2019. The call money rate has lost over 25 bps, but leading banks have cut the one-year minimum lending rate by only 5 bps. Across the bond market, transmission is almost complete at the shortest end, but less so at the longer end (See Picture 1 below).  One reason is the tight systemic liquidity: it is well-known that a cut in interest rates is transmitted better when liquidity is surplus (recall how rates fell quickly when deposits surged into the banking system post demonetization).

 

 Pic 1: Transmission of Interest Rates

 

Even if RBI’s OMO bond purchases and dollar/rupee swap auctions were to make the system more liquidity-neutral, there is still the problem of bank credit coverage. Monthly data on gross deployment in bank credit shows a decline in year-on-year credit to micro and small manufacturing enterprises, but a sharp rise in personal loans and loans to service sectors. The share of agriculture in incremental credit has fallen, while the share of services has increased. These data points suggest that the growth in bank credit is not broad-based; rather, it seems to be benefitting services and retail loans at the cost of employment-intensive sectors. And that cannot be good for stimulating demand growth.

Another concern is the uncertainty around key variables in the near term. The MPC’s inflation and growth forecasts are based on several assumptions including a normal monsoon, achievement of 3.4% fiscal deficit by the government, softer global growth, crude oil at $67/bbl and exchange rate of Rs.69 to a dollar. One or more of these assumptions could be violated in the coming months. The first Skymet forecast has already indicated the possibility of a below normal monsoon. If the US-China trade talks come to a successful conclusion, global growth could pick up, and crude prices are likely to increase in tandem. The government’s fiscal prudence is in question given pre-election promises of loan waivers and less-than-budgeted indirect tax collections. Given the risks to the baseline assumptions, future policy actions will be data dependent to a large extent.

Even if macro conditions align with MPC assumptions, the space for further easing is limited. If a real interest rate between 1.5% to 2% is considered necessary to attract savings, then given the predicted inflation range for FY20 (2.9-3.0% in H1,3.5-3.8% in H2), the maximum possible cut would be between 25 to 50 basis points. These cuts are not likely to come in before August, when the new government is in place and more data is available about the monsoon. In other words, the rate cut is something to cheer about, but markets are not sure about the extent and timing of further rate cuts. At this point, all eyes are on the national elections, the outcome of which will influence policy for the next five years.

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