After three consecutive rate cuts of 25 basis points (bps) each, markets are pricing in another 25 bps rate cut on 7 August, when the monetary policy committee of the Reserve Bank of India meets. However, is there a case for a 50 bps rate cut? Let us look at the global and domestic economic backdrop and evaluate.

First, the global backdrop. Since RBI’s last rate cut, a number of central banks, such as Australia, Indonesia, Korea, Russia, Turkey and, more importantly, the US, have reduced rates. Going forward, the US Federal Reserve will stop its balance sheet contraction and the European Central Bank will be expanding its balance sheet again. Central banks are reacting to adverse economic data from Asia and Europe triggered by trade tensions. US President Donald Trump has upped the ante in the tariff war with China by declaring 10% tariff on goods not being subjected to tariffs right now ($300 billion). Manufacturing activity is slowing, as supply chains are moving to ensure lowest possible taxes.

Since November 2018, India’s exports have also seen a dip as global trade decelerated. Together, manufacturing and services exports, constitute almost 20% of gross domestic product (GDP) and are likely to face significant headwinds in the wake of lower global growth.

On the domestic front, consumption has been the key driver of the economy. Since FY12, the share of consumption in GDP has increased by more than 300 bps. Lately, share of investment has also been inching up. However, the upcycle has turned from Q3FY19 onwards. High frequency data shows a decline in two- and four-wheeler sales, while services activity is also showing signs of deceleration as fewer goods are being transported and consumers cut back on spending.

Real estate sector has been impacted as housing finance companies (HFCs) did not have enough liquidity to lend to the sector (10% of GDP). Capacity utilization levels, which were increasing, may see a drop again, thus pushing investment revival a little ahead. What explains the change in domestic economic cycle? Tightening liquidity and now credit standards seem to have impacted demand. Disbursements by non-banking financial companies (NBFCs)/HFCs have come off. Banks have tried to fill up the gap, but the deeper reach of NBFCs/HFCs has meant not all borrowers have been able to get access to credit.

So how do we kick-start growth? One way is to expand the fiscal deficit. However, the government has indicated that there is limited fiscal room as of now as it is looking at fiscal deficit of 3% of GDP in FY21. This is in line with the global narrative of passing over the mantle of reviving growth to central banks. RBI has remained ahead of the curve in the current economic cycle. Not only did it provide the much-needed liquidity to the economy, but it has already reduced policy rates by 75 bps, and changed its policy stance to neutral and then to accommodative.

However, the much-needed transmission is lacking as consumers and NBFCs/HFCs moved to banks for additional credit requirement, and banks were forced to raise deposit rates to get incremental deposits to lend. However, with persistent surplus liquidity by RBI and decline in deposit rates by a few large banks, transmission will be visible. While transmission will help in ensuring pass-through of earlier rates, the real rates still remain on the higher side, thus impeding a sustainable recovery. Lower EMIs will help the consumers in either saving or consuming more.

Even if the RBI cuts rates by another 50 bps, the policy rate will be at 5.25%, thus ensuring a 1.5% to 2% range of real policy rates over expected inflation over the next two years. RBI’s own estimates project CPI inflation at 3.3% and 3.7% for FY20 and FY21. Notably, for the last two years, inflation has been lower than RBI’s mandate of 4%. Structural factors suggest a benign inflation environment. Global oil prices are unlikely to move up because of positive supply shock by US shale oil and move to renewables. The global food grain stock-to-use ratio is at the highest level in almost nine years. In India, too, we have large food stocks. In a slowing domestic and global economy and fiscal consolidation, core inflation is also unlikely to increase as pricing power is limited.

Given the above backdrop, time has come for the RBI to step on the pedal to drive growth as upward risks to inflation are limited, but downward risks to growth are much higher. This calls for a 50 bps cut in interest rates, which will go a long way in changing the negative sentiment.

Sameer Narang is chief economist at Bank of Baroda.

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