Photo: Aniruddha Chowdhury/Mint
Photo: Aniruddha Chowdhury/Mint

Transmission and liquidity are key factors

How will the cumulative effects of the 150 bps of cuts that began since January 2015 impact the economy?

Macroeconomic conditions and government policy actions in India have turned decisively favourable since the monetary policy review on 2 February 2016. Reserve Bank of India (RBI) governor Raghuram Rajan acknowledged as much on Tuesday after another review, yet chose to be measured in response by slicing the repo rate by just 25 basis points (bps). A basis point is one-hundredth of a percentage point.

To be sure, RBI has guided for an accommodative monetary policy stance, and retained its gross domestic product (GDP) growth estimate at 7.6% for this fiscal year.

The focus now shifts to the cascade effect: how will the cumulative effects of the 150 bps of cuts that began since January 2015 impact the economy? Will transmission improve, borrowing costs fall, and investment and growth find traction?

We certainly expect transmission to improve. While this will support consumption growth, it won’t be enough to kick-start the private sector investment cycle in a meaningful way—at least not in this fiscal year.

That’s because the rate cuts of the past 15 months have had an asymmetric and limited impact. How the road ahead is would thus be a function of correcting this anomaly.

A little explanation is in order. Bank lending rates haven’t fallen in sync with rate cuts of the recent past. Bank base rates—or the benchmark lending rate that banks set depending on their cost of funds—are down only ~60 bps compared with the 125 bps reduction in the repo rate prior to Tuesday’s cut. Not surprisingly, interest rates on home loans are cheaper only to that extent.

But with banks forced to set their lending rate based on marginal cost of funds w.e.f. 1 April 2016, transmission will improve. Also, the recent reduction in small savings rates reduces longstanding structural rigidity in India’s interest rate regime. This, too, will improve transmission.

Another point to note is that the rate cuts of the past have hardly moved government bond yields because of fiscal deficit concerns. But the lowering of the fiscal deficit target in the Union budget to 3.5% of GDP for fiscal 2017—compared with 3.9% last fiscal year— has had a constructive impact and the 10-year yields have come off by over 30 bps.

On the other hand, the corporate bond markets had responded well to RBI’s signals of the past. In the first half of 2015, there was an almost 100 bps decline in interest rates on commercial papers and certificates of deposit. That trend, however, started to reverse later and now, with liquidity conditions tight, rates are clawing up.

We believe such asymmetries will—and are—getting corrected and softer interest rates would spread well across borrowing classes. Liquidity conditions also need to improve to facilitate this. Steps such as reducing the minimum daily maintenance under the cash reserve ratio, the portion of deposits that banks need to keep with the central bank, and the marginal standing facility, a window through which banks borrow from RBI when liquidity dries up, hopefully, would do just that.

Ultimately, a secular reduction in borrowing costs will support private consumption, as will the coming increase in wages of government employees and pensions of veterans.

And a normal monsoon—which seems a likely scenario at this point—will kindle rural demand and balance growth in private consumption. Currently, the economy is firing on only one cylinder—urban demand. Banks will also stoke consumption because of their bias for consumer loans over investments because of higher delinquencies in the latter.

That should help improve capacity utilization rates and pave the path for new investments. However, we expect private sector investments to start picking up only towards the fag-end of fiscal 2017. And this will be a moderate pickup, and not broad-based improvement. That’s because corporates are yet to deleverage materially and banks remain cautious because of high and rising bad loans in their books.

The upshot is that India’s investment-to-GDP ratio, which has been falling over the past five years, will only mildly revive this fiscal year.

We expect another 25 bps cut from RBI in its June monetary policy review as growth-inflation dynamics improve further.

As for Consumer Price Index-based inflation, it appears to be on the path to RBI’s target of 5% for fiscal 2017, with growth, particularly in the non-agricultural sectors, expected to grind up only slowly. Baked into this is the assumption of soft crude oil and commodity prices, a normal monsoon, and a dovish US Federal Reserve.

Dharmakirti Joshi is chief economist at Crisil.