In a move that surprised many economic observers, Reserve Bank of India Governor Raghuram Rajan cut the benchmark interest rate, also called repo rate, on September 29 by 50 basis points (100 basis points are one per cent), thus paving the way for cheaper home, auto and corporate loans. With this rate cut, which was the fourth since January 2015, the Reserve Bank has reduced the repo rate by a total of 125 basis points. The moot point is whether the RBI decision will make the desired impact on the economic growth of India which is below its potential.
The repo rate is the mother of all interest rates. It is the rate at which banks can borrow money from the Reserve Bank on a pledge of security with the option of repurchase. The lowering of the repo rate reduces the cost of funds for the banks and an increase does the opposite. Once the cost of the funds comes down, it is expected that the banks will pass on the benefit to borrowers. Unfortunately that does not always happen as there are other factors which have a bearing on the interest rate that the banks charge and borrowers pay.
Governor Rajan was reportedly reluctant to reduce the repo rate fearing that it would have an adverse bearing on inflation in India, especially in the backdrop of below normal monsoon and other global developments. However, under intense pressure from the Finance Ministry and industry, he yielded and lowered the key interest rate by 50 basis points, which is also the biggest in over three years, to boost national growth.
Following the cut, the repo rate stands at 6.75 per cent, the lowest in four-and-a-half years. The other rates which include the reverse repo rate and the bank rate, which are linked to the repo rate, have too been lowered by a similar margin.
Rajan justified the bigger than the expected rate cut reduction saying consumer inflation was likely to be at 5.8 per cent, below the 6 per cent target for January. The focus should now shift to bringing inflation to around 5 per cent by March 2017, he had said, adding that the RBI would remain vigilant to signs of monetary policy adjustments that were needed to stick to the "deflationary path".
While opting for the rate cut, the RBI also drew comfort from the decision of the US Federal Reserve to delay its first hike in interest rates in nine years. The interest rates in the US are near zero and any increase at this juncture would have repercussions for the global markets, jeopardizing the fragile economic recovery. Fears here are that a hike in the interest rate in the US might trigger a flight of capital creating problems for the external sector. The status quo by the Federal Open Market Committee (FOMC), which decides interest rates in the US, gave the RBI space and comfort to ease its monetary stance.
ON THE NEGATIVE SIDE
On the negative side, the RBI lowered its economic growth forecast for the current fiscal year to 7.4 per cent from its previous projection of 7.6 per cent. This is in line with a reduction in the growth forecast of India by other international agencies.
Although the Indian Government in its Economic Survey in February this year had set a growth target of 8.1 to 8.5 per cent for 2015-16, it might be difficult to achieve it in view of the subdued Gross Domestic Product (GDP) growth rate of 7 per cent in the first quarter (April-June) of the year. The Finance Ministry will have to undertake a mid-term review of the economy and revise its growth estimates.
However, a revision of growth projections is as best as a sideshow. The real issue is what will happen to the interest rates which individuals and corporates have to pay to borrow funds from the banks. It may be pointed out that while the RBI had reduced the repo rate by 75 basis points since January, the banks have lowered their rates by only 30 basis points, reflecting a poor state of monetary transmission.
Rajan flagged the issue when he said, “while the Reserve Bank's stance will continue to be accommodative, the focus of monetary action for the near term will shift to working with the Government to ensure that impediments to banks passing on the bulk of the cumulative 125 basis points cut in the policy rate are removed."
In his comments on the monetary policy, Finance Minister Arun Jaitley welcomed the rate cut by the RBI and signalled the banks to follow suit. "This decision of the RBI will significantly provide policy support to the real economy and help in the recovery process. We are looking forward now to the transmission of these cuts which will effectively help to boost confidence and investment. They will also help to realize the economy's medium-term potential growth rate," the Minister said.
The banks on their part responded to the monetary policy stance and reduced their lending rates, within hours of the RBI announcement. State Bank of India (SBI) lowered its base rate by 40 basis points, thus setting the trend for industry. Several other State-owned banks followed the market leader to the benefit of borrowers and industry. Leading private sector banks ICICI and Axis Bank too indicated that they would bring down the lending rates. It will also have a benign impact on bond markets.
In her comments, ICICI Bank CEO Chanda Kochhar said, "Clearly interest rates will come down, base rates will come down. A large part of the cut will get transmitted. When I say a large part of the thing (repo rate) will get transmitted, it should mean more than half."
INDUSTRY WELCOMES RBI DECISION
As expected industry, which has been pitching for an easy monetary policy for long, welcomed the RBI’s decision to cut the rates by half a percent. The industry chambers hailed the decision of the Reserve Bank.
CII Director General Chandrajit Banerjee said, "Industry is happy that the RBI has finally recognised the weakness in underlying economic activity and the need for a reduction in borrowing rates to drive a recovery. Action by the RBI has removed considerable uncertainty with regard to the direction of borrowing costs faced by industry. The corporate sector will now be in a better position to drive a recovery in investment and growth."
Although industry and borrowers are happy, there is one section which will have to bear the brunt of the easy monetary policy and no one has talked about them. That group includes savers, senior citizens and those who depend upon interest income for livelihood.
A reduction in interest rates will invariably result in a cut in fixed deposit rates. Banks have started cutting them across all maturities. And more importantly, the Finance Ministry has indicated that it would review the interest rates on small savings post office schemes and other popular instruments like the PPF and the NSC. The savers, which constitute a silent majority, are unfortunately dispersed, not organised and not as vocal as the industry chambers are. Hopefully the Government will not sacrifice their interests in its zeal to promote industry and economic growth in India.