A constrained RBI descended from its high perch on 17 April in a surprisingly large step-down of 50 bps. It premised this upon the need to align interest rates closer with growth – which in its judgment is below trend - and a sequential softening of core inflation from subduing demand. In addition, liquidity access from the marginal standing facility was eased by expanding the borrowing limit for banks to 2% of outstanding net demand and time liabilities. Notwithstanding this shift of stance towards growth, the central bank flagged significant upside risks ahead to inflation, arguing this limits the room for future easing.
How does one interpret this? The larger-than-expected cut sits uneasily with the noteworthy, existing risks to inflation. It is also a significant departure from the RBI’s baby-step approach of not so long ago.
Possibly, the RBI would be inhibited in a graduated rate-cutting course if administered prices see a revision soon, which may have necessitated a front-loaded reduction. But that only highlights the inherent contradiction between the aggressive easing and embedded inflation risks.
It could also be that a 25 basis point might have been ineffective in transmitting to banks, which were unlikely to respond to a small reduction by lowering loan rates but may have been quick to reprice liabilities instead. A significant cut in the policy rate – in addition to the benefits from 125 bps lower cash reserve requirements since January – should ensure that banks pass on the reduced cost of funds to their borrowers, alleviating their interest burden and unclogging stalled, pipeline investments.
A more significant impact is upon market sentiment, as the uplift in stock prices, bond and swap rates betrayed after the announcement. Equity markets like lower interest rates and respond positively to cuts. The external sector would benefit too if relatively more foreign capital poured into the stock market than the riskier and much more volatile debt market. Attending to growth – that most believe troughed at 6.1% last quarter - at this juncture will attract foreign investors as earnings will improve hereon.
Monetary and liquidity conditions are now considerably easier with these policy moves, which the RBI expects will stabilize growth at around 7%, India’s post-crisis trend. Factoring in exchange rate depreciation, monetary conditions are even looser: a weighted index of monetary conditions shows the combined effects were easiest in January, the lagged impact of which should be felt now onwards.
The central bank projects growth to rebound from an expected 6.9% in 2011-12 to 7.3% in 2012-13, which is midpoint of the government’s 7.6%(+/-0.25) and the IMF’s 7% forecast. The upside risks it highlights arise from oil and commodity prices, fiscal slippage and large government borrowings, supply-demand mismatches in food and the current account deficit.
Looking ahead, the forward guidance provided by the RBI talks of limited scope for future rate cuts. That might just be belied by global price movements, especially commodities, as they react to a cooling China: Commodities are already cracking under the pressure whereas oil prices are coming off in response to positive geo-political developments. If this scenario plays out positively, both fiscal and current account deficits are likely to fall in line, offering more space for monetary response from the RBI. Fingers crossed, 2012-13 might not be so bad in that case.
Renu Kohli is a New Delhi-based macroeconomist; she is a former staff member of the International Monetary Fund and Reserve Bank of India.