Mumbai: The Reserve Bank of India (RBI) is expected to make more rate cuts to support the slowing economy, but the government’s increasing borrowing needs to support a widening fiscal deficit could affect the timing and size of the moves.
The following looks at how the government’s borrowing could affect the outlook for interest rates:
How has the central bank responded to the global crisis?
Since October, the central bank has cut the repo rate, its main lending rate, by 350 basis points to 5.5%. It has cut the reverse-repo rate, the rate at which banks park funds with it, by 200 basis points since December to 4%.
The last rate cuts came in early January. At a policy review at the end of January, the central bank kept rates on hold and said banks needed to pass on previous cuts to customers.
How much does the government want to borrow?
The government unveiled an interim budget on Monday for the fiscal year 2009-10 beginning on 1 April that included Rs450 billion in fresh borrowing needs for the current fiscal year.
Acting Finance Minister Pranab Mukherjee said that the budget deficit for the current fiscal year would balloon to 6% of gross domestic product (GDP), the biggest shortfall in 7 years and a big jump from the original deficit forecast of 2.5% of GDP. The widening reflects spending to stimulate the economy.
The deficit was projected at 5.5% for the 2009-10.
The government said its gross market borrowing for 2008-09 would need to rise to Rs3.06 trillion from the previously announced requirement of Rs2.61 trillion.
Just last week, the government announced an increase in bond sales of Rs460 billion. The interim budget added another Rs450 billion in borrowing, although the government said it would not tap the market for these funds.
Why could a bigger deficit affect interest rate cuts?
Suresh Tendulkar, chairman of the Prime Minister’s Economic Advisory Council, said that the high fiscal deficit may force the central bank to wait before cutting rates.
Increased government bond issuance could drive market interest rates higher, making it difficult for commercial banks to cut their rates in line with central bank rate cuts. So further central bank rates cuts would lack potency.
Equally, both expansive fiscal and monetary policies could revive fears of inflation, which as recently as August was well above 12% compared with the latest reading of 4.4%.
Still, Subir Gokarn, Asia-Pacific chief economist with Standard & Poor’s, said that inflation is a low priority for now and policy makers must focus on boosting growth and creating jobs.
“There is no private investment happening, and the argument that there should be lower public sector borrowing as it crowds out private borrowing makes sense in a normally functioning economy and today is not a normal scenario,” Gokarn said.
“Keeping a lid on market interest rates may mean the central bank has to fund the budget gap,” says J. Moses Harding, head of global markets at IndusInd Bank.
RBI, could buy government bonds and cut bank cash reserve requirements.
“But I am afraid these measures will not be good enough, and the RBI may need to resort to private placement or monetization in order to avoid pressure on rates,” Harding said.
Until the mid-1990s, the government could raise funds by issuing treasury bills directly to the central bank, a process called monetizing the fiscal deficit.
But analysts say monetizing the deficit could back-fire longer term by feeding money supply and inflation.
What will the central bank do now?
Further cuts in rates may depend more on economic data, with the central bank responding to further signs of slowdown and moderation in inflation.
Anindya Dutta, country treasurer at Calyon Bank, said that the next rate cuts may happen once inflation drops below 4% from the current 4.39%. A Reuters poll shows data on Thursday is expected to show that wholesale price index, the main measure of inflation, rose 4.01% in the year to 7 February.
“I doubt whether the central bank will be moved by the bond yields trend or fiscal prudence as they would have known about the government’s borrowing needs,” Dutta said.
Goldman Sachs argues that the central bank will go slow on rate cuts from now. It sees rates coming down 50 basis points before April.
It says bigger rate cuts will have a limited impact because under election restrictions, the government can’t impose a cut in commercial banks’ minimum deposit rates.
“We believe the inability to cut administered savings rates below 3.5% before elections may act as a binding constraint, not allowing the RBI to cut rates further,” it said.
Sailesh Jha, senior regional economist at Barclays Capital in Singapore, expects the central bank to cut rates by 50 basis points by end of this month and expects interest rates to bottom out at 2% later this year.
“The current policy making is a bit like firing cannons which, though not very accurate, have a big impact rather than shooting carefully aimed bullets,” Jha said.
Kotak Mahindra Bank see the central bank cutting rates 100 basis points by the end of March.
Nomura expects a 50 basis point cut by the end of March and another 100 basis points of cuts by June. It says deeper cuts are needed to ensure a greater pass-through to lending rates for business and individuals.