
MPC review: Rate cut not ideal yet. Rely on surplus liquidity and operation twist instead

Summary
The challenge is to formulate a policy that boosts wholesale credit without triggering inflation, currency instability, or increased risks in retail lending. Let the repo rate to act as a signalling tool to boost the sentiment without stoking the other risks.The upcoming monetary policy is crucial for several reasons, given the environment and uncertain outlook making the selection of policy tools critical. A repo rate cut, if it were to happen, will need to take cognisance of the impact on the rupee, given the narrowing rate differential between the US and India. Furthermore, increasing financialization of the economy has intensified the interplay between macro-micro and financial market, heightening the risk to financial market stability. A liquidity infusion and operation twist may be more effective than only relying in the repo rate.
An analysis of 3,444 listed companies’ H1FY25 results reveals flat-to-moderate revenue growth, a moderating trend in operating margins, and a resilient credit risk profile. Revenue pressures have primarily arisen from reduced pricing power, global influences on exports, normalization of post-pandemic demand, and a slowdown in urban consumption. While falling general price levels have impacted top line growth, the correction in key raw material prices has helped margins for companies facing demand disruptions.
Capex trends
Although broad-based capital expenditure has been lacking for some time, sectors such as iron & steel, cement, data centres, logistics, and renewables are showing healthy capex spending using internal accruals and debt. The analysis indicates that the lagged effects of monetary policy are visible in FY25, with the overall increase in cost of debt around 200 basis points (bps) during FY22-H1FY25. Despite the rise in interest costs in FY24 and FY25, the adverse impact is not evident in the coverage and leverage ratios, as most balance sheets have deleveraged post-pandemic.
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However, an interesting observation is the compressed trend in return on equity (ROE), and for mid-sized entities it is quite low. Large corporates have an ROE of around 10%, translating to a post-tax excess return over risk-free return of 2.5% (assuming a risk-free rate of 7% and a corporate tax rate of 20%). In contrast, mid- and small-sized corporates do not achieve returns above the risk-free rate. While ROE is a necessary but not a sufficient condition, it is a critical determinant for promoters (shareholders) considering capex. Sustainable improvements in ROE can only be achieved by boosting demand, increasing operational efficiency, or productivity gains. The sustained healthy margins for corporates suggest that operational efficiency is in a better shape but difficult to improve further in the medium term. Therefore, it is evident that the lack of broad-based capex is primarily due to demand uncertainty and a volatile operating environment, rather than solely the high cost of financing.
In the retail lending space, average lending rates range from 9% for prime home loans to 30% for microfinance and short-term unsecured loans. Unsecured loans typically have rates between 15% and 30%, depending on the borrower's credit profile. It is reasonable to assume that a 1%-2% reduction in interest rates will not significantly ease the debt burden for borrowers in the unsecured lending segment. Rather it could act as tailwinds for retail-focused NBFCs to lend more.
At this juncture, a rate cut is unlikely to stimulate investment growth, given the deluge of uncertainties. Instead, it could provide a boost to fresh retail lending by banks due to the external benchmark lending rate-based regime. Though, the performance of retail assets in banks’ books is considerably better than that for small- to mid-sized NBFCs, it could be attributed to K-shaped recovery. However, with the rising household debt, encouraging fresh retail lending by cutting rates at this time would be inappropriate.
Additionally, a repo rate cut alone will not sufficiently reduce the cost of funding for wholesale credit, which is critically needed. Banks are facing elevated loan-to-deposit ratios, making it challenging to significantly reduce deposit rates. They are burdened with high-cost term deposits, making it difficult to lower lending rates without compromising their margins.
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The challenge is to formulate a policy that boosts wholesale credit without triggering inflation, currency instability, or increased risks in retail lending. The appropriate approach to address these complex dynamics is to boost liquidity in the system on a sustained basis. This would ease pressure on deposit rates and, subsequently, lower the marginal cost of funds-based lending rates. However, the risk of excessive liquidity is a sharp drop in short-term rates, which could be detrimental to the rupee and encourage NBFCs to overly rely on short-term borrowings. To mitigate this risk, the solution is to deploy an operation twist—simultaneous selling of short-term bonds and buying long-term bonds. In essence, infusing liquidity by purchasing long-term bonds, followed by an operation twist to lower the long-term yield curve and raise short-term yields to an appropriate level. Let the repo rate to act as a signalling tool to boost the sentiment without stoking the other risks.
Soumyajit Niyogi, director at India Ratings & Research, a Fitch Group Company
(The views expressed here are their own and do not reflect those of the organization)