The Reserve Bank of India (RBI) has delivered one of its most aggressive doses of rate cuts in this cycle. The repo rate has been cut by a cumulative 350 basis points (bps) in just three months.
In comparison, after the dotcom bust it took three years to cut rates by as much. The swift policy response has been successful in softening money market rates and injecting surplus liquidity into the system.
While a lot has been done, we judge that another 150bps worth of repo and reverse repo rate cuts and 200bps cut in the cash reserve ratio will be required. First, despite the repo rate being cut by 350bps, banks have cut their lending rates by only about 150bps. This stickiness in lending rates could be due to the speed at which policy rates have been cut. In October, banks were still paying high interest rates on fixed deposits. As these deposits are repriced at lower rates, lending rates should fall.
Even in normal times, monetary policy works with long lags. But these are far from normal times. The risk of another round of capital outflows and liquidity shortage could be deterring banks from cutting deposit rates aggressively. So the financial system requires continuous doses of liquidity injection for a longer-than-usual period to bring confidence back into the system.
Second, even if liquidity is sufficient and the cost of borrowing falls, banks are reluctant to lend because of high credit risk. Ensuring sufficient credit supply will be a key challenge for RBI. Cutting policy rates aggressively, particularly the reverse repo rate, is one tool that can be used to discourage banks from parking excess funds at RBI.
Third, with elections due by May and an interim budget to be presented in February, any fiscal stimulus is more likely to be announced once the new government comes into power. In the interim, this places even more onus on monetary policy.
Fourth, the balance of risk is likely to remain tilted in favour of growth over inflation. We expect the economy to trough only in the second quarter of 2009, with gross domestic product growth slowing from 9.0% year-on-year (y-o-y) in fiscal 2008 to 6.8% this fiscal and further to 5.3% in the next.
Meanwhile, wholesale price inflation is likely to drop sharply to negative y-o-y readings by around mid-2009. A high base may be exaggerating this decline, but there are fundamental factors at work, too, such as much lower commodity prices and increasing spare economic capacity. Therefore, we judge that policy rates have to be cut further to keep real rates from rising very fast.
In conclusion, we see the status quo in the January policy as a pause, rather than an end to RBI’s rate cutting cycle.
Sonal Varma is India economist, Nomura Holdings Inc.