How much, Mr Das: Rate cut of 40 or 25 bps?

The Indian central bank will surely cut the growth projection for the year and pare the policy rate yet again at the next bimonthly meeting of its monetary policy committee (MPC) that ends on October 4.

Since February, the Reserve Bank of India (RBI) has reduced its policy rate by 110 basis points (bps) in four successive meetings of its policy making body, including a rather unconventional 35 bps, bringing it down to 5.4 per cent, its nine-year low. One bps is a hundredth of a percentage point. 

As far as growth is concerned, at the August MPC meeting, the real GDP growth estimate for 2019-20 was pared from 7 per cent in June to 6.9 per cent. For the first half of the current fiscal, the projection has been in the range of 5.8-6.6 per cent and, for the second half, 7.3-7.5 per cent — with risks somewhat tilted towards the downside. 

With the June quarter GDP growth dropping to a six-year low of 5 per cent, the RBI is left with very little choice but to revise its growth estimate downwards, once again. The question is by how much? Not many analysts are willing to bet even on a 6.25 per cent growth for the current year but the central bank probably will not be that bearish, particularly against the backdrop of the aggressive government actions to improve the investment climate and encourage consumption. We can expect the RBI to bring down its projection for the year to 6.5 per cent. It can also play safe and give a range of 6.4-6.6 per cent. 

At this point, not inflation but the slowing growth in Asia’s third largest economy, which wants to get into the $5 trillion club by 2025, is the primary concern of the RBI. This is why even though with every successive policy rate cut the marginal utility of the cut comes down, it may cut the rate again. Here too, the question is: How much? It could be 25 bps. Or, to complement the previous 35 bps rate cut, it could be a 40 bps cut to bring the policy rate down to 5 per cent. Why not 15 bps? That will be too small a dose and won’t cut much ice with the market. 

The MPC, at this juncture, is faced with a Hobson’s choice: If it goes for a mild cut (15 bps), the market will shrug it off and, if there is a deep cut, it may create an impression that the RBI is done with the rate cut cycle. It needs to frontload the cut and, at the same time, dangle the carrot of at least one more cut in the near future. It could be between a 25 bps and 40 bps cut. My bias is towards 40 bps. The overnight indexed swap market is indicating an approximately 65 bps rate cut in India, bringing it down to 4.75 per cent, in phases. 

RBI Governor Shaktikanta Das has recently said future rate cuts would depend on the incoming data with a caveat that India cannot have low interest rates like in the advanced economies. In the past few weeks, the US Federal Reserve, the European Central Bank, and the central banks of China, Indonesia and Philippines have cut rates. The Bank of England has maintained status quo and may continue to do so till the final Brexit outcome. Other three central banks to keep the rates unchanged are the Bank of Thailand, the Bank of Japan and the Swiss National Bank (maintaining a negative rate of -0.75 per cent). The only hawk in the dule of doves is Norway’s central bank which has recently raised interest rates for the fourth time in the past year by 25 bps to 1.5 per cent. 

For the record, India’s retail inflation marginally rose to 3.2 per cent year-on-year in August from 3.15 per cent in July but continues to remain below the MPC’s target (4 per cent with a band of plus/minus 2 per cent). While the food price inflation inched up to 3 per cent from 2.4 per cent in July, the so-called core inflation or non-food, non-fuel manufacturing inflation moderated to 4.2 per cent from 4.5 per cent in July. In August, the RBI projected retail inflation at 3.1 per cent for the second quarter and 3.5-3.7 per cent for the second half of 2020. There does not seem to be any major threat to this projection.

Monetary transmission

Till the August policy announcement when the RBI cut the rate by 35 bps, the transmission of the policy rate cut was a little over one-third — 29 bps against 75 bps rate cut since February. It seems to have improved marginally. We will see further improvement in monetary transmission with the banks being forced to link their floating rate retail and personal loans and loans given to micro and small enterprises to an external benchmark. The State Bank of India has already announced linking them to the repo rate (the policy rate at which RBI gives money to the banks) and others are likely to follow suit. 

This is perplexing as banks are allowed to borrow just 25 bps of their net demand and time liabilities, a loose proxy for deposits, from the RBI’s repo window at 5.4 per cent, offering government bonds as collateral. They can borrow more from the variable repo window (where the rate is higher — between 5.41 per cent and 5.64 per cent) but the access is capped at 75 bps for the industry. Essentially, not even 1 per cent of the banks’ liabilities is linked to the repo rate. 

How are they linking their loans to this external benchmark?

They can borrow from term repo windows where money is given for 14 days, twice a week, and at times even for a longer duration but the term repo market is still nascent. Banks can use different benchmarks for different loan products and, once fixed, the spread over the external benchmark cannot be changed for three years. It will be interesting to see how the new regime pans out. Incidentally, most large banks’ average cost of deposit is less than the repo rate and large private banks enjoy as much as a 3.5-4.5 per cent net interest margin.

The columnist, a consulting editor of Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd.  Twitter: @TamalBandyo