Amid a depressed global economy, uncertainty over the fate of the European Union and slowing domestic growth, the silver lining for 2012 is that the Reserve Bank of India (RBI) will start easing monetary policy. The central bank has already signalled that it has reached the end of its tightening cycle. And although we’re not sure how long the policy rate will remain at the peak, most economists believe we’ll see the beginning of rate cuts in the March-June quarter. Before that, the central bank is expected to reduce its cash reserve ratio (CRR), which might happen as early as January, depending on the inflation data. Will the interest rate cuts lead to a rebound in the economy? If so, how long does it take for the cuts to take effect? Will banks start making more profits and will markets start to go up as monetary easing takes effect? History should provide a guide.
But while RBI cut its policy rate dramatically in 2008, there are several reasons why it might be inappropriate to consider that period as a precedent. First, it included the Lehman collapse and although a break-up of the euro zone will have even worse consequences, the consensus is still that a break-up is unlikely and the region is likely to muddle along. Next, it was also the period when governments went in for a strong dose of fiscal stimulus, an option that’s closed at present. A better period to consider, therefore, would be the impact of the rate cuts during the downturn of 2001-03.
In the fourth quarter of 2000-01, gross domestic product (GDP) growth at factor cost and at constant (1999-00) prices fell to 1.8%, in part because of negative growth in agriculture. Manufacturing growth fell to 2.1% in the first quarter of 2001-02 and bumped along thereabouts for the rest of the fiscal year, improving to a respectable 7.3% only during the second quarter of 2002-03.
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RBI swung into action in February 2001, when it started reducing CRR, but it was much higher than at present—the reduction was from 8.5% to 8.25%. Soon after, in April 2001, RBI reduced its repo rate from 9% to 8.75%. The chart shows the subsequent reductions in the repo rate and the CRR. The last CRR cut at that time, to 4.5%, came in August 2003, while the bottom in repo rates during that particular cycle was reached in March 2004, at 6%.
What about inflation? In April 2001, when the rate cuts began, wholesale price inflation was 5.5%. In October 2000, it had been as high as 7.5%. But by March 2002, when the repo rate was cut to 8%, Wholesale Price Index (WPI) inflation was as low as 1.8%. Inflation remained low thereafter—even at the time of the last rate cut for the cycle in March 2004, WPI inflation was at 4.8%. Clearly, inflationary pressures were lower during that cycle than at present and this helped RBI in reducing rates.
What was the effect on capital formation? In the fourth quarter of 2000-01, when the first rate cut happened, gross fixed capital formation growth was -4.9%. That growth rate improved soon after, albeit in fits and starts. But by the time of the final rate cut to 6% in March 2004, growth in gross fixed capital formation (during the last quarter of 2003-04) was a high 17.8%.
And finally, we come to the effect on the markets. Between 2 April 2001 and 1 April 2002, the Nifty was more or less flat, while the Bank Nifty gained 12%. Between 1 April 2002 and 1 April 2003, while the Nifty lost 13.5%, the Bank Nifty gained 18.7%. The rate cuts had led to a change in the fortunes of bank stocks. That’s because banks’ profitability improves during periods of falling interest rates, as they book profits on investments. For instance, the profits of all scheduled commercial banks on sale and revaluation of investments went up almost three times in 2001-02 compared with the previous year. Note, however, that the market as a whole didn’t do well despite the rate cuts and it was only in 2003-04 that the market went up sharply, as GDP growth came roaring back that year to 8.5%.
RBI’s repo rate is currently at 8.5%, while the cash reserve ratio is at 6%. Much depends on how inflation pans out. But it’s worth noting that the interest rate cuts in 2001-03 too were gradual—it took almost a year for the repo rate to be cut from 8.75% to 8% and another year for it to go to 7%.
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