BackFactors that prompted RBI’s bold move
Subdued inflation, sluggish GDP growth and a deteriorating credit growth momentum are the likely factors
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The 50 basis point (bps) cut in the policy rate took many by surprise. What prompted such a bold move by the Reserve Bank of India (RBI), which, in the past, has been much more conservative in easing rates? We highlight a few factors that probably influenced the central bank’s decision.
Subdued inflationary pressure was a reason. Retail inflation was 3.78% and 3.66% in July and August, respectively, which was lower than what RBI had projected earlier (4% in August). Meanwhile, Wholesale Price Index-based inflation is currently at a record low of -4.95% and production-side, gross domestic product (GDP) deflator is also close to zero.
Apart from the uncertainty related to the food price dynamic, underlying inflationary pressure remains subdued, and given the sharp correction in global commodity prices, upside risks to pipeline inflation also remain limited, which probably provided RBI the comfort to go for a 50 bps rate cut.
A basis point is one-hundredth of a percentage point.
Consumer Price Index (CPI)-based inflation will start rising from September, due to an adverse base effect, but is likely to remain comfortably below the 6% mark by January. While RBI has reduced its inflation forecast to 5.8% for January from 6% earlier, we think the risks to this baseline forecast are to the downside.
Sluggish economic recovery is another reason. Economic recovery has been sluggish and uneven for a long time, and this probably prompted RBI to finally go for a bigger rate cut. Indeed, the April-June GDP growth moderated to 7%, from 7.5% in the previous quarter, with net exports subtracting from growth and private consumption slowing somewhat. Excluding discrepancies, GDP growth was much lower at 6.1%, albeit being slightly higher than the previous quarter’s 5.7% out-turn. Irrespective of the headline 7% GDP print, it is clear from various high frequency indicators (Purchasing Managers’ Index, credit growth, non-oil and non-gold imports, capacity utilization) that economic momentum remains weak.
The government on its part is trying its best to front-load public investment (as is evident from recent fiscal data), but the magnitude of such spending is clearly not sufficient to lend support to growth meaningfully, as is reflected from the latest GDP growth trend. The room to provide substantial fiscal stimulus remains limited, given the constraint on the fiscal deficit front, which then leaves it upon RBI to provide some support to growth by easing the monetary policy. We think the current growth-inflation dynamic provided enough comfort to the central bank to front-load the rate cut.
Deteriorating credit growth momentum is the third reason. RBI’s move could have also been prompted by a deteriorating credit growth momentum, which has hit a multi-decade low. As per RBI’s latest data, nominal credit growth has slowed further to 9% year-on-year (y-o-y) by end-August (from 12% y-o-y in the same period last year), with loans to industrial sector falling to as low as 5% y-o-y.
While we acknowledge that cutting interest rates is not the panacea for propping up credit growth, given that its slowdown is reflective of several structural problems in the economy and the banking sector, it could help on the margin to generate a positive demand shock. There’s also the fact that real interest rates are higher than other emerging market (EM) peers. India’s real interest rate (policy rate minus CPI inflation) is currently higher than EM peers such as China and Indonesia. As a result, from a cost-benefit perspective, India likely stands to gain more from a rate cut at this stage. With reserves adequacy strength having improved materially, an incremental rate cut of 50 bps is unlikely to pose any significant threat to India’s broader financial market and exchange rate stability.
Lastly, weak and delayed monetary transmission has been frustrating RBI for some time and probably the 50 bps rate cut is to nudge commercial banks into cutting their lending rates substantively and expeditiously, which is critical to support a robust investment-led economic recovery.
With RBI having cut the repo rate by 50 bps in one single clip, it appears that we are close to the end of the rate cut cycle. Based on our inflation projection for 2016-17 (average CPI inflation of 5%), we think there could be scope for the central bank to cut the repo rate one last time by 25 bps, but this will likely happen only after the government presents the national budget in February.
Kaushik Das is India economist at Deutsche Bank.
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