RBI’s first rate cut in five years is small but can be effective

The banking system has been facing a severe liquidity deficit since December. Total money created by the RBI—or base money—grew by 3.5% (year-on-year) in the week ending 24 January, far lower than the 6.3% growth in the comparable week of 2024. Growth in ‘broad money’ has also slowed down. Some of this systemic tightness was due to routine outflows (advance tax, goods and services tax payments). However, the RBI’s interventions in the forex market to prop up the rupee were also a big contributor.

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These issues have been somewhat addressed in recent weeks. The rupee has been allowed to depreciate a little, and the RBI has infused durable liquidity through open market operations, swaps and a cash reserve ratio (CRR) cut. The result is that the RBI’s operational target—the call money rate, or the interest rate charged by lenders for short-term loans to each other—is closer to the policy repo rate and has fewer spikes beyond the RBI’s ‘policy corridor’(see chart).

Tighter provisioning norms for project financing and liquidity coverage have been deferred until at least 31 March 2026. With this, and the policy promise to be proactive in providing liquidity, banks should find it easier to transmit the rate cut.

FPI flows: The pull factor

Between October 2024 and January 2025, foreign portfolio investors (FPIs) took out a net $19.19 billion from India’s stocks, contributing significantly to the rupee’s fall. In theory, a rate cut could reduce India’s rate advantage for FPIs and push the rupee lower. But the reality is that growth, not interest rates, pulls foreign investment into India. Sustained economic growth, together with macroeconomic stability, attracts inflows; a period of actual or expected decline in growth and/or policy uncertainty has the opposite effect.

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Current capital outflows across emerging markets are mainly a response to changing US policy, the threat of a trade war, and the resulting upside risk to inflation. By cutting rates, the RBI sends a message that it is ready to support growth, confident that the worst of inflation is over. At the same time, a neutral stance signals that it remains vigilant on inflation, and retains the flexibility to alter direction if required.

Bank margins

Banks usually lose net interest margins (NIMs) when rates are cut. The impact may be less this time, as rising deposit rates have already been compressing bank margins. Going forward, margins are likely to be flat or fall slightly, depending on bank-specific features. On the assets side, loans given on external benchmark-linked rate (EBLR) re-price down faster than marginal cost lending rate (MCLR) loans. So, their relative shares in a bank’s loan book will determine the speed of adjustment. On the liabilities side, banks with a higher share of current and savings account deposits will benefit, as term deposits are repriced only on maturity.

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Although nominal deposit rates will go down, the Union Budget 2025-26’s tax proposals are expected to attract deposits of ₹40,000-45,000 crore, mainly from senior citizens, on the back of tax savings. In addition, if a rate cut, along with the budget’s consumption push, increases demand for bank loans, it could boost overall profitability in the banking sector.

The times they are a-changin’

For most central banks, 2024 was a year of rate cuts. But in 2025, renewed uncertainty has brought in caution: now, there’s an intent to take action when and as needed. The US Federal Reserve paused rates because US growth is strong, while tariffs and tax cuts pose an inflation risk. In contrast, India’s growth has slowed, while headline inflation has fallen below 6%, thus giving the RBI a window of opportunity to ease rates.

A 25-basis-point cut is small and will impact the cost and volume of credit slowly (a lag of two to three quarters is expected). But it signals a clear communication of policy shift. Small policy actions can be powerful if the intent and objectives are expected and understood, as pointed out by a recent RBI study. Against the backdrop of a back-to-VUCA (volatility, uncertainty, complexity, and ambiguity) world, the RBI has put out a prudent and practical policy.

The author is an independent writer in economics and finance.