Positive surprise

BS OPINION

The element of surprise means that the rate cut should have the maximum impact "" thereby testifying to Governor Bimal Jalan's thesis that if the market is to be surprised, it should be with good news. The central bank has put forward two reasons for reducing the rate.

One is that the current low level of inflation and the good monsoons, with their beneficial effect on prices, justify the rate cut. The second reason is that it would reduce the flatness of the yield curve.

There's no doubt that the inflation rate in terms of the wholesale price index is low, at just below 4 per cent. The good monsoons should help keep prices down and neutralise any hike in domestic fuel prices as well as the rise in commodity prices.

But more important than these, the need for a repo rate cut was probably caused by the weight of excess liquidity. Surplus funds with banks had led to the yield curve becoming inverted at the short end, with the 91-day Treasury bill yield slipping below the repo rate.

That the market thought the RBI was paying too high a price for repos was clear from the fact that, on an average, an astonishing Rs 40,000 crore were being parked in repos.

One effect of the rate cut will be a reduction in the difference between Indian and US interest rates, reducing the arbitrage opportunity.

This could reduce the inflow of dollars, and reduce the upward pressure on the rupee. Lower interest rates at home will make external commercial borrowings less attractive, and that could lead to a pick-up in domestic credit.

Non-food credit growth has been sluggish so far, and one reason for the flat yield curve is that banks are putting their money in gilts. The central bank's lower interest rates further could help that objective.

If everything goes according to plan, it may also kill two birds with one stone "" while the reduced arbitrage and ECB inflows ease the pressure on the rupee (the rupee is already over-valued on an REER basis, a metric closely followed by the RBI), lower inflows will also mean that the RBI need not mop up quite so many dollars and release rupees into the market, resulting in an increased liquidity.

Taken together, all these factors could help make the yield curve more steep by taking interest rates at the long end to more realistic levels.

The RBI's decision to offer 6.2 per cent on 12-year state loans, a rate at least 50 basis points above comparable central government paper, is a clear signal that the central banks wants the yield curve to steepen.

But market players are sceptical about the RBI's ability to steepen the curve in view of the abundant liquidity. The last repo rate cut saw long-term rates also come down substantially.

If the RBI now lowers the Bank rate in an attempt to signal cheaper credit for companies, that would signal lower long-term rates, thus flattening the curve all over again.

Whether the RBI realises its objectives would depend on how dollar inflows react, and the continued liquidity in the market.