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Explained: Why RBI may cut interest rates tomorrow and why it may not be enough

Udit Misra
In simpler terms, growth is likely to dip further when the Q2 data is revealed later on in the year.

As the Reserve Bank of India’s Monetary Policy Committee announces its bi-monthly policy review on October 4, it would know that the Indian economy is facing its worst slowdown since the dip in economic activity following the global financial crisis of 2008-09. As this chart from Care Ratings shows, economic growth has been decelerating for the past five quarters ( that’s the last 15 months).

Yet, from RBI’s perspective, thankfully, at least the inflation rate (that is the rate of increase in prices) both at wholesale (WPI) and retail (CPI) levels has been well under control.

That is why, since the start of this calendar year, the RBI has been able to aggressively cut the benchmark repo rate the rate at which it lends to the banking system. A repo rate cut brings down the costs of raising funds for the banking system and signals a cut across the board.

However, despite cutting the repo rate by 110 basis points 100 basis points equal one percentage point since February, RBI has not been able to get banks to pass through the full cut; the pass-through has been just about 40 basis points. That’s because the repo rate is not the most important determinant of the cost of funds for banks. The bigger determinants are the rate of interest banks pay depositors and the rate of interest that depositors earn on small savings schemes such as the Sukanya Samriddhi Yojana or the public provident fund that the government runs. The fact that banks, especially the public sector ones, have been struggling with a mountain of loans that went bad did not help matters as each quarter banks had to redirect their profits (which would have otherwise helped them lend to new businesses) towards plugging the gap made by such non-performing assets.

What is likely to happen on October 4 policy review?

Notwithstanding the lack of transmission in the past, the RBI is likely to cut repo rate by anywhere between 35 to 40 basis points. That’s for a variety of reasons.

One, inflation is under control and there is room to reduce interest rates without fueling a surge in the price level. Two, if the transmission is weak, a deeper cut is required to achieve the goal. Three, the government has just cut corporate tax rates in its bid to incentivise more investments; cutting interest rates will further help that goal as it would make it cheaper to borrow money. Lastly, as with many banks now willing to link the interest rates on new loans to the repo rate, a larger rate cut will help in quicker transmission of rate cuts, says Suvodeep Rakshit, Vice President & Sr. Economist, Kotak Institutional Equities.

Will it help to boost economic activity?

A cut in repo rate cannot make matters worse; it can only help at this juncture even though even Chetan Ghate, a member of the RBI’s MPC, has questioned how far can rates be cut. That’s because the broader momentum of the economy is downhill and it is possible that in the second quarter of the financial year that is, July-September witnesses just as weak an economic growth as in Q1, when GDP grew by only 5 per cent.

The chart from Nomura research alongside maps Nomura s monthly activity index (MAI), which is a weighted average of nineteen high-frequency indicators. It is meant to gauge underlying economic momentum. According to a recent report by Nomura research, growth of Nomura s MAI has been moderating since H2 2018… it is now below the trough hit during the global financial crisis.

In simpler terms, growth is likely to dip further when the Q2 data is revealed later on in the year.