There are two reasons why Reserve Bank of India (RBI) governor D. Subbarao should announce a further cut in policy interest rates on Tuesday.
One, there is growing evidence that the economy will weaken further this year and inflation will continue to fall. It seems likely right now that India will experience mild deflation in the middle of 2009 before inflation moves back into positive territory. The inflation scare of mid-2008 is now a memory as commodity prices collapse and companies lose pricing power (food inflation continues to be a threat to the poor).
Such a slowdown should ideally be met with greater public spending and lower interest rates. The first is the responsibility of the government while the second is the responsibility of the central bank. India right now has more or less fired all its fiscal ammunition, with the combined deficit of the Central and state governments expected to be in double digits. Fiscal irresponsibility during the boom years has ensured that almost the entire burden of fighting the slowdown will have to be borne by RBI.
Illustration: Jayachandran / Mint
The question right now is to what extent Subbarao should cut rates. Since mid-September, he has been aggressively hacking away at the repo and reverse repo rates, at which the central bank lends to and borrows from banks for short periods of time. We think the central bank will have to settle for more modest cuts in the rest of 2009.
A quick look at the recent history on inflation and interest rates would help. The year 2003 was the last time average annual inflation—as against the year-on-year number that is widely reported each week —was as low as it may fall to in 2009. The repo rate then was down to 5% compared with the current 5.5%. There is no reason to believe that RBI cannot go below that figure, but we believe it makes sense to ease more gradually from now on. A 50 basis point cut would be the safe thing to do.
Subbarao has also been slashing the cash reserve ratio (CRR), or the proportion of funds that banks need to compulsorily keep with the central bank. The severe liquidity squeeze that sent money market rates sky-high in early October has eased. Banks are quite happy to park their surplus short-term funds with RBI and use growing portions of new deposits to buy government bonds rather than lend to companies.
This is a problem of risk aversion and cannot be dealt with by a CRR cut.
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