Limited impact

Interest rate reduction may not push credit offtake

In another out-of-turn policy meeting last week, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) reduced the policy repo rate by 40 basis points to 4 per cent. The reduction in the interest rate was necessitated by the deteriorating economic outlook. In the RBI’s assessment, the combined impact of compression in demand and supply disruption will keep economic activity depressed in the first half of the fiscal year. The economy is expected to recover in the second half, but given the uncertainties, the RBI expects growth to remain in negative territory in the current fiscal year. On the other hand, the central bank expects headline inflation to remain firm in the first half of the fiscal year and ease in the second half. The outlook on both growth and inflation is highly uncertain at this stage. High-frequency indicators underscore the kind of damage the lockdown has caused to output. While the RBI has done well to act proactively, it remains to be seen as to what extent the rate cut will help the Indian economy.

While lending rates have eased in the recent period, they may not be sufficient to revive activity at this stage. For instance, the latest RBI data shows that the outstanding non-food credit declined by Rs 1.36 trillion since the beginning of the fiscal year till May 8. Differently put, a 75-basis point rate cut in March did not result in a spike in credit offtake from the banking system. There could be both demand- and supply-side reasons for the decline in total outstanding credit. It is likely that firms are not willing to add more debt because of overall economic uncertainty. However, it is also possible that banks are unwilling to lend, expecting an increase in non-performing assets after the moratorium ends while overall demand remains weak. If the economy contracts as the RBI and many other agencies are expecting, it is highly unlikely that borrowers can generate enough revenue and operating profits to pay off dues in the current fiscal year.

Thus, it is likely that another rate cut may not actually help improve credit offtake at a time when the government is expecting the banking system to do the heavy lifting. Indian banks, particularly in the public sector, were not in a very strong position even before the spread of Covid-19. An excessive burden of reviving economic activity and directed lending can increase difficulties for banks. Further, it is likely that the banking regulator would allow one-time restructuring of debt at some point, as borrowers may find debt servicing difficult because of weak economic conditions. But the suspension of the Insolvency and Bankruptcy Code for a year could weaken the position of lenders. The code gave lenders an upper hand and the fear among promoters of losing control resulted in a settlement of a large number of cases. Therefore, it will be important for the government to carefully draft the rules so that the code doesn’t become irrelevant. In fact, suspension for a full year itself should be reviewed.

There are several moving parts at the moment which could limit the impact of monetary action. On the policy front itself, uncertainty associated with the inflation outlook would limit the efficacy of policy action. At a broader level, the actual impact will depend on the progress in containing the virus and administrative efficiency in opening up the economy.