RBI rate cut — too little, too late?

April 23, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The RBI Governor cut the repo rate on April 17 quite reluctantly, even hinting there wouldn’t be another cut soon. Perhaps, he was under pressure from elsewhere, compelling him to look beyond inflation which had been his sole criterion in raising the repo rate.

The surprise was that the RBI cut the rate by 50 bps in one go. What the market expected was 25 bps because that is the speed at which the RBI has been moving since March 2010, except on one occasion   when the rate was raised by 50 bps. Will the drop in repo from 8.5 to 8 percent make all the difference?

A 50 bps reduction does not mean that banks will slash their interest on credit correspondingly. After all, the repo is the rate at which banks borrow from the RBI. These borrowings are a small part of their total operations. What matters more is the interest on deposits which banks may take some time to reduce. Therefore, at best, the reduction in interest on credit can be 25 bps. That is unlikely to rev up the debt market.

Take home loans which are generally for long periods and therefore the interest rate becomes an important consideration. On a loan of 2 million rupees payable in equal instalments over 20 years, the saving in interest with a 25 bps reduction would be 170 rupees a month. That is too little for any home buyer to be excited about. That is also true of the corporate sector though the stock market reacted favourably.

The cut in the repo rate is nevertheless a good beginning. But it has to be carried forward before it can regenerate investment and the economy. The RBI had done it in 2008 when the economy had slowed down following the world financial crisis. The repo rate was 9 percent in 2008 when Lehman Bros collapsed and the RBI cut it by 100 bps in October. That was followed by another 50 bps cut in November and 100 bps in December. In just three months, the repo was down 250 bps from 9 to 6.5 percent. Not that there was no inflation. Going by WPI, inflation was 12 percent in August 2008 which declined thereafter in spite of the sharp cut in interest rates. But consumer prices, mainly due to food inflation, were high. Food inflation is a problem by itself unrelated to the rate of interest.

The choice before the RBI is really to have a high interest rate with low growth and high inflation or to have low rate of interest with high growth and high inflation. The latter would be a better choice. That would require that, as in 2008, the repo rate has to be cut not by 25 or even 50 bps but by 100 bps to get it down to 6.5 percent in the next three months and take investment back to 30 percent of GDP.

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