Interest-rate sensitive stocks have been rallying hard on expectations of a rate cut by the Reserve Bank of India (RBI) at its policy meeting next Monday. Opinion about the rate cuts has ranged from warning the central bank about the danger of stoking inflation by cutting rates to a demand for a 50 basis points cut, in addition to reducing the cash reserve ratio (CRR) to improve liquidity. The arguments and counter-arguments are well-known. Those in the rate cut camp point to the low gross domestic product (GDP) growth number for the fourth quarter, to the fact that the Index of Industrial Production was flat in April, to the dire external environment, to lower crude oil prices and lower core inflation and to the plunge in adding new capacities. The no-rate-cut camp talks of high headline inflation, of inflation trending higher when domestic fuel prices are increased, of rate cuts not being enough to kickstart investment, of the continued strength of consumption in the economy and of the need for RBI to hold its fire to force the government to act on the real supply-side issues.
One way of reading the tea leaves is to look at what RBI has done in the past when growth slowed down dramatically. You don’t have to go too far back—in the third quarter of FY09, at the time of the Lehman crisis, GDP growth fell to 5.8%, better than the Jan-March 2012 GDP growth rate of 5.3%.
What did RBI do at the time? It cut the repo rate from 9% to 8% in October 2008 and then delivered a rate cut every month till January 2009 and further cuts in March and April. By the end of April 2009, the repo rate had fallen to 4.75%. What’s more, these rate cuts started at a time when Wholesale Price Index (WPI) inflation was very high. WPI was 10.7% in October 2008 but fell all the way down to 1.2% by April 2009.
But then, we’re not in the mid of a Lehman moment now, in spite of warnings of the European crisis being Lehman 2.0. Nobody expects world GDP to shrink this year, as it did in 2009, nor are oil prices likely to go down so sharply. Sure, a disorderly unravelling of the euro zone could be worse than Lehman, but we’re not there yet. So nobody expects the RBI to cut rates so dramatically. But what the comparison with 2008 brings out is that the central bank will not hesitate to cut rates even if inflation is high, provided it is convinced that growth is slowing drastically, because lower demand will result in lower core inflation.
But why not just look at the situation last April when RBI governor D. Subbarao delivered his surprise 50 basis points rate cut? GDP growth had fallen to 6.1% for the third quarter of FY12, WPI for March had come in at 6.9% while manufactured non-food products inflation had come down from 5.7% in February to 4.6% in March.
Since then, headline inflation has gone up and even core inflation was up a tad in April. The April policy easing was based on a slowdown in core inflation. The May Purchasing Managers’ Index data showed a jump in prices charged in the services sector, while output prices showed some deceleration. Much depends therefore on Thursday’s inflation print. But then, if growth slows down, core inflation too should come down, as demand weakens.
In its last policy statement in April 2012, the RBI said it expected growth to recover in the fourth quarter of FY12, and in fact it’s become worse. It said, “Based on the current assessment, the economy is clearly operating below its post-crisis trend.” That’s even truer now. Simply put, if RBI believed that growth of 6.1% in the third quarter of FY12 was clearly below the trend or sustainable non-inflationary growth rate, calling for a rate cut of 50 basis points, shouldn’t a growth rate of 5.3% in the fourth quarter lead to more rate cuts?
Bankers insist, however, that a rate cut without a cut in CRR will have little effect. That’s because tight liquidity has prevented banks from lowering rates. On 25 May 2012, banks’ credit-deposit ratio was a high 76.67%, constraining the ability of banks to lend. The chart shows that credit-deposit ratio at this time of the year is the highest in over a decade, an indication of how tight liquidity is. RBI has been infusing liquidity through open market operations. A CRR cut will not only ease the pressure on banks but will also allow RBI to intervene in the foreign exchange market without a liquidity squeeze.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at email@example.com
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