India’s central bank is facing a strange problem of diminishing utility of its rate cuts. In under a year, Reserve Bank of India (RBI) governor Shaktikanta Das has axed policy rates by 135 basis points and has flooded the banking system with a surplus liquidity of nearly 2 trillion. Das has said that he is not done yet.

But this expansionary monetary policy has not so much as made a ripple on the surface of the economy. Growth has only worsened, falling to a six-year low of 4.55% in the September quarter. Manufacturing is showing signs of recession, contracting by 1% during the quarter. Add the clogged credit flow to firms, and the picture gets ugly. The animal spirits of private investment are far from being awakened.

Graphic by Satish Kumar/Mint
Graphic by Satish Kumar/Mint

In fact, the central bank has had to prune its own growth forecasts and economists believe one more such pruning is due on Thursday. As such, GDP growth forecast has been lowered three times by RBI.

It would seem that the biggest and fastest policy rate cuts since the global financial crisis have failed to have an impact. But if Das believes in doing whatever it takes, rate cuts are not the only instrument any more. Ergo, the action is outside the monetary policy committee’s ambit now.

The biggest challenge for RBI is to restore trust in its financial markets. This means making mutual funds and banks lend to firms, including non-banking financial companies. As Nomura Financial Advisory and Securities (India) Pvt. Ltd’s chief economist Sonal Varma warned in a note, until credit flow restarts with vigour, growth will only worsen. “Even though the next GDP print is likely to have the benefit of a favourable base, without amelioration of tight credit conditions and an improvement in monetary policy transmission, we find it difficult to fathom a sustainable recovery. We expect Q4 GDP growth to remain sub-5% (4.7%) and FY20 GDP growth at 4.9% y-o-y, i.e. a prolonged bottoming out process still lies ahead," said the note. The brokerage firm expects FY20 GDP growth to be 4.9%, compared to RBI’s projection of 6.1%.

RBI also needs to prod banks to lower lending rates and perhaps manage market yields. “While nominal MCLR is down 40 basis points since March, on RBI easing, real MCLR has shot up by 120 basis points with core WPI inflation collapsing on weak demand," said analysts at Bank of America Merrill Lynch in a note on 2 December.

Part of the transmission problem will be resolved as more and more loans get linked to the repo rate, or other market benchmarks. To be sure, RBI needs to wait and see the effects in the coming quarters.

Meanwhile, RBI will have to ensure that the 2 trillion worth surplus liquidity begins to at least support the sovereign bond market. This will be tough considering that the government will have to borrow more due to modest tax revenue collections.

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