A reduction in the repo rate by the Reserve Bank of India (RBI) now seems like a done deal especially after the gross domestic product growth for FY19 came at a five-year low of 6.8%, with the fourth quarter growth at 5.8%. The case for an accommodative monetary policy is made stronger as retail inflation is below RBI’s mandated target of 4%.
To that extent, the sharp fall in government bond yields shows that markets are pricing in rate cuts not just on Thursday but also in the next meeting.
However, the central bank’s problem is not that it has not cut rates or even reduced them as much as warranted. Its main challenge is to make money available to the real estate sector at a price where investment gives a reasonable return. Banks give more than half of the credit to the economy and their lending rates have hardly budged. Past rate cuts of the central bank have only benefited the government, the biggest borrower.
As such, RBI has indirectly financed fiscal deficit and contributed to inflation, even as growth continues to be pulled down by a stagnant private sector investment.
Transmission has been RBI’s biggest challenge despite the central bank nudging banks and at times even browbeating them into lowering their lending rates. The failure of policy transmission has become stark after non-banking financial companies (NBFCs) suffered a liquidity freeze triggered by the collapse of Infrastructure Leasing and Financial Services Ltd.
Analysts believe that while a rate cut would offer immediate succour to the markets, decisive measures to give liquidity to lenders in general and NBFCs in particular would go a long way in dealing with the slowdown in the economy. “Transmission has been a challenge and it is more essential that bank and market rates transmit the rate cuts. Towards this end, liquidity should be pushed to close to neutral—maybe towards surplus in the near term to partly offset the credit squeeze in the NBFC sector," according to analysts at Kotak Institutional Equities.
To be fair, the central bank has infused liquidity consistently. What its liquidity operations lack is the ability to push money into the hands of the final borrower. For this, RBI needs to incentivize lending to non-banks but consistent with their risk profile.
The coming months are not likely to be easy as most analysts expect transmission clogs to continue and growth to be sober. The central bank can, however, lay the groundwork to prevent the slowdown from deepening further. All it needs to do is to direct its liquidity infusion to the small borrower instead of adding to the heft of the government.