Having cut rates aggressively, the central bank’s decision to leave policy rates unchanged or prune them further was a close call. The 25 basis points rate cut, therefore, does not come as a complete surprise. The main reason behind the token cut (one basis point is one-hundredth of a percentage point) is to send a signal to banks to lower their deposit and lending rates further.
The string of conventional and unconventional measures undertaken by the Reserve Bank of India (RBI) over the last six months has successfully injected ample liquidity into the system and lowered overnight rates. The key concern at this stage remains the incomplete pass-through of policy rate cuts to borrowers. Rising credit risk (tighter lending standards) and the government’s large market borrowings (leading to higher government bond yields) have reduced the effectiveness of the monetary policy transmission.
To be fair, the current slowdown in credit growth could be partly due to banks tightening lending standards, but declining demand for credit is probably also an important factor. Indeed, with the sharp slowdown in GDP growth from more than 9.0% to 5.3% in the fourth quarter of 2008, it would be unusual were demand for credit not to weaken. In this context, RBI’s 20% non-food credit growth target for FY10 appears optimistic.
In an environment with slow credit demand and excess liquidity, we see no incentive for banks to keep deposit rates high. As past high-cost deposits are repriced at lower rates in coming quarters, we expect lending rate cuts to follow.
Accommodating the government’s large borrowing and lowering sovereign bond yields remains an ongoing challenge. We judge that RBI will expand its balance sheet by more than its 1H FY10 commitment of Rs80,000 crore as the Union government’s fiscal deficit is revised higher in the final budget.
The good news is that with Wholesale Price Index inflation heading into negative territory in coming months, RBI has a window to expand its balance sheet without worrying about inflation.
Overall, our view is that RBI’s rate cutting cycle is not over yet, but it is nearing an end. Limited fiscal leeway, rising real interest rates, much weaker economic activity (we expect GDP growth at 5.3% in FY10, below RBI’s target of around 6.0%) and the need to signal lower lending rates to banks all suggest that a further 25-50 basis points of rate cuts are still in store.
While the market is fixated on rate cuts, perhaps even more important for RBI will be to find ways to enhance the effectiveness of the substantial monetary policy easing already in place.
Sonal Varma is India economist, Nomura Financial Advisory & Securities (India) Pvt. Ltd.