Go for a deep rate cut, Mr Governor4 min read . Updated: 05 Dec 2008, 11:50 PM IST
Go for a deep rate cut, Mr Governor
Go for a deep rate cut, Mr Governor
The yield on the benchmark 10-year government bond dipped to 6.71% this week, its lowest since April 2005. The cost of five-year interest rate swaps or derivatives contracts that are used to guard against interest rate fluctuations also dropped to 5.25%, something not seen since May 2004.
In April 2005, the repo rate was 6% and the reverse repo rate 4.75%. And, in May 2004, the reverse repo was even lower, at 4.5%. Today, the repo rate is 7.5%, after a 150 basis points rate cut in October and November, and the reverse repo rate, at 6%, has been unchanged since mid-2006. This means the market is expecting a 150 basis points cut in the repo rate and a 125 basis points cut in the reverse repo rate. (One basis point is one-hundredth of a percentage point.)
Will RBI pander to market expectations?
I think it will, to a large extent.
RBI should go for a deep cut in both the policy rates if it wants to bolster the sagging economy.
Also Read Tamal Bandyopadhyay’s earlier columns
On Thursday, the European Central Bank that sets the interest rates for the 15-nation euro zone, cut its policy rate by 75 basis points, the deepest cut in its history, to 2.5%. The Bank of England, too, cut its policy rate by 100 basis points to 2%, its lowest. Both the central banks are not ruling out any further rate cuts. The US Federal Reserve’s policy rate already stands at 1%.
The choice before RBI is to tinker with the policy rates, opting for smaller dosages of cuts spread over a period, or go for a deep, effective rate cut now. Unlike many other global central banks, it can go for deep cuts, as it has a lot of headroom—the policy rates are still fairly high. This will give confidence to the financial system as well.
By the time RBI realized the magnitude of the crisis and swung into action by cutting interest rates and the cash reserve ratio—the portion of deposits that banks need to keep with the central bank—the confidence of the financial system was shattered. And it has not yet been rebuilt. Banks are still not comfortable in lending to individuals as well as corporations as they are not confident that liquidity will remain in the system. They also continue to pay high rates to depositors for the same reason—they want to hoard money for rainy days. The biggest challenge before the central bank is to restore the confidence of the financial system and convince banks that the liquidity is here to stay. This can only be done by deep rate cuts.
RBI should not have a problem in doing so because wholesale price-based inflation has dropped to 8.4%, a seven-month low, and it should come down further in coming weeks. Most analysts see the inflation rate at around 5% by the end of this fiscal year and less than 2% by the middle of the next.
The biggest worry before the central bank is the economic slowdown. Economic growth slowed to 7.6% year-on-year for the quarter ended September, led by moderation in both the industry and services sectors, but we have not yet seen the worst of it. In October, India’s exports shrank for the first time since March 2002, following a decline in demand for Indian goods in the US and Europe. Weakening domestic demand, falling asset prices and rising job losses are all contributing to the gloom that is being intensified by banks’ aversion to lend.
A deep cut in interest rates will be a strong signal to encourage banks to start lending and cut both loan as well as deposit rates. RBI must also make it clear that reverse repo is the real policy rate. Since it infuses money into the system at the repo rate, this is the policy rate of a liquidity-starved economy. But if RBI wants to give a signal that liquidity is here to stay, the reverse repo rate, or the rate at which it sucks out liquidity, should be the policy rate. Lowering of the reserve repo rate will also discourage banks to park excess money with the central bank as they will earn less from this.
A cut in interest rates should be accompanied by a strong fiscal stimulus package from the government, if it wants to revive economic activity and arrest the slowdown. RBI should also come out with a one-time relief package for the stressed borrowers. Under the current norms, non-payment of interest or principal for a quarter or 90 days makes a loan a non-performing asset. This forces banks to provide for such loans and dents its profitability. At the same time, it blocks avenues for borrowers for raising fresh loans to tide over funds’ crunch. The regulator should not dilute the prudential norms, but a one-time relief will help both the financial system and the real economy.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to firstname.lastname@example.org