Opinion | The case against rushing forth with a lending rate cut

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) will meet next week to decide on whether to cut its policy interest rate or not. Will it cut the repo rate once again, as it unexpectedly did in its previous meeting? The MPC’s exclusive mandate is to ensure that headline inflation as defined by the Consumer Price Index (CPI) is within a band of 2-6%. That is why India’s monetary framework is called “flexible inflation targeting”: it does not focus on a single target number, such as 2% in the case of the European Central Bank (ECB). The MPC meeting’s minutes and language will be closely parsed to glean what it really means, not just says.

There is a whole industry of central bank watchers whose business is to accurately read the minds of monetary policy makers. Hence, words such as “stance” and their nuances are important. By all indications, most market participants (and maybe the government too), expect the MPC to cut the repo rate by 25 basis points in April and perhaps again in June. This will make all borrowers happy, among whom the biggest borrower is the government itself, whose debt mountain is more than ₹80 trillion. Even a 25 basis points rate cut translates into an annual saving of ₹0.2 trillion.

As CPI inflation is predicted to remain below 4% in the next few months, this affords the MPC a chance to remain accommodative of borrowers. Growth is slowing down around the world, with even the US Federal Reserve now indicating a pause in tightening, or even rate cuts, instead of rate hikes as was anticipated in December. The Chinese are expected to unleash a strong monetary stimulus and lower their rates. The ECB will keep rates near zero and German government bonds are already at yields below zero. The Japanese are also in monetary expansion mode. With practically the whole world in a monetary easing mode (and mood), can India remain isolated? Surely we too must cut rates?

Here are some contrarian factors to consider. First, if the purpose of rate cuts is to spur private industrial investment, it is doubtful whether it will work. Private capital expenditure was booming even when interest rates were in double digits. Corporations are still too leveraged and balance sheets are stretched. Profitability is low and cost inflation is high. Capacity utilization is not high enough to induce a new round of investment. The still-too-strong rupee is hurting exports and inviting a deluge of imports, making domestic firms uncompetitive and unwilling to invest in new capacity. For small and medium enterprises, it is not the cost of credit but its access that is the main hurdle.

Second, India’s fiscal situation is getting grimmer by the day. State governments’ budgets overshot last year, and will do so again this year. Loan waivers, their share of costs for the universal health insurance scheme (Ayushman Bharat) and grants to sectors like sugar will all add up. The states now depend more than 90% on market borrowing to fund their fiscal deficit, unlike in previous years. At the centre, collections on goods and services tax (GST) has been consistently below target for more than a year, causing a shortfall of ₹1 trillion. Some of the government’s own liabilities have been parked on the balance sheet of the Food Corporation of India. If you count the entire public sector borrowing requirement, the combined deficits and payables like GST compensation to the states, it adds up to close to 10% of GDP. It has been reported that a big part of power sector loans may turn into non-performing assets (NPAs), and electricity distribution companies (discoms) are still cash starved.

Third, it must be pointed out that CPI inflation is low due to the impact of food prices, especially fruits, vegetables, pulses, and sugar. Core inflation (excluding food, petrol and diesel) is constantly above 5% and rising slightly. Oil prices have gone up by 35% in recent months and might go above $70. Food inflation is seasonal and unstable, and with a deficient monsoon, it may shoot up. RBI’s own survey of households still shows that inflationary expectations are 8.5%. The season of salary increments is also upon us, and God forbid if corporate employees get anything less than a 10% pay hike. The government itself is trying its best to ensure that minimum support prices (MSPs) work in favour of farmers. How long then can one assume that CPI inflation will remain benignly low at 3%? Meanwhile, currency in circulation is nearly 20% above its pre-demonetization level, which was deemed to be excessively high at the time.

Fourth, one has to pay attention to depositors, who form a silent but much larger class. The government recently increased the interest rate paid out on people’s provident fund corpus, keeping in mind the interests of savers.

Fifth is the liquidity tightness situation triggered by the Infrastructure Leasing and Financial Services mess. This money scarcity is not consistent with low rates.

Lastly, consider financial stability. Stock market flows are fickle. Even though they are robust now, they can exhibit a sudden stop or reversal at the slightest provocation. The macro-economy may be much safer today than in July 2013, but all it takes is a sudden dollar flight, rapid increase in the current account deficit, a spike in oil prices (and inflation) and a monsoon failure to add up to an incendiary mix.

If we want to avoid a panic reaction of tightening in such a situation, even if it is not very likely, it is best to maintain the repo rate at the current level and take a pause for now. 

Ajit Ranade is an economist and a senior fellow at the Takshashila Institution.