Why the RBI’s 25 bps rate cut was too little

January 30, 2015

(Any opinions expressed here are those of the author and not necessarily those of Thomson Reuters)

The Reserve Bank of India’s decision to reduce interest rates by 25 basis points on January 15 was a pleasant surprise, not because of the cut but due to the timing, as the bi-monthly policy review was still a couple of weeks away.

The central bank’s assessment was that decline in vegetable and fruit prices was sharper than expected and price pressure on cereals had eased. International commodity prices, particularly crude oil, had also dropped. The government’s reiteration of its commitment to a strict fiscal roadmap also helped. In the end, the RBI must have been convinced that price trends were not temporary but durable.

But how big will the impact of the repo rate cut be? Markets were undoubtedly elated by the unexpected announcement, and there were indications that the change in the RBI’s policy stance may be enduring, with more cut rates likely during the year.

But industry players seem unimpressed. First, the cut has to be reflected in the rate that commercial banks charge their borrowers. That, however, is not automatic and it is quite possible that the rate of interest on bank credit may not be reduced to the full extent the repo has been.

Second, even if commercial banks fully respond to the repo reduction, the impact on EMIs for home and car loans will not be significant. For instance, against a loan of 25,00,000 rupees payable in 20 years, the reduction in EMI will be 482 rupees from the monthly payment of 24,959 rupees. That is not going to rev up demand for homes.

The impact will be even less for the manufacturing industry. According to the Annual Survey of Industries, interest payments by industries were 26 percent of profits before tax. The 0.25 percent cut in rate will increase pre-tax profits by a mere 0.27 percent. Similarly, reduction in cost of production and prices will be a mere 0.06 percent.

Clearly, the 25 bps reduction is not a motivating force and will not revive industrial growth. What is relevant, however, is the change in the RBI’s thinking. If inflation weakens further, more rate cuts will follow. Had the January rate cut been significant, the impact would have been enough to revive India’s stagnant industries. Therefore, the RBI should cut the repo rate by at least 50 bps at its next policy review on February 3.

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