Originally Published 2016-10-12 10:45:42 Published on Oct 12, 2016
Implications of a repo rate cut

As expected, new Reserve Bank of India (RBI) Governor Urjit Patel has reduced the repo rate (rate at which commercial banks borrow from the RBI), which will lead to a much-awaited reduction in banks’ deposit and lending rates. Since December 2015, the repo rates have fallen over a period of one and a half years by 1.75 per cent. Yet the rate of credit growth in the economy has fallen from 30 per cent to 22.3 per cent. Maybe a larger cut would have done the trick but the RBI in its latest monetary policy has chosen to be cautious and has brought down the repo rate by only 0.25 per cent to 6.25 per cent. The assumption underlying this move to reduce the repo rate by 25 basis points is that retail inflation will be 4.5 per cent in the future months ( 2018).

The government has been pitching for lowering of interest rates for a long time. The previous Governor, Raghuram Rajan, did not oblige it, choosing to remain independent.  The Indian economy is worth $2.29 trillion and banks play an important part in dispensing credit which is the backbone of business. In the last few months, though manufacturing growth has picked up new investment growth has fallen by 3.1 per cent in the second quarter of the current fiscal year. A reduction in interest rates will give a boost to demand for investment, no doubt. But on the whole the entire banking sector needs a huge overhaul so that a repo rate cut gets translated into more intensive banking activity.

In a country of India's size, it is amazing to realise that bank finance plays relatively a small part and only around 60 per cent of the people have bank accounts. Most small-scale units survive by taking loans from informal non-banking financial institutions rather than the banking sector. The public sector banks are in dire straits and there is a huge amount of Rs 5.9 lakh crore worth of NPAs which hike up their operational costs. It has made them very cautious and selective. A ‘bad bank’ is being talked about which will take on the NPAs of all commercial banks and function as an asset restructuring body. Even so, with the lowering of interest rates some big industrial house may start taking loans and default on payments.

Today the need is for making public sector banks more accountable and they have to clean up their balance sheets. They need fresh capital and in the last Union Budget, Rs. 25,000 crore was promised for recapitalisation of public sector banks. Only when banks become strong, the much-needed universal banking can take place and banks can advance credit to enterprises and start-ups. The IMF has predicted that India's GDP growth will be around 7.8 per cent and food inflation will be 4 per cent. Whether there is something to spoil this prediction is yet to be seen. So far the monsoon has been good and the agricultural growth should be around 3 per cent. The Niti Ayog predicts a 6 per cent increase in agricultural growth. The output of pulses is slated to go up so that there are no severe shortages. But on the whole agriculture is an unpredictable sector.

Predicting the rate of inflation is also tricky because there is still the awaited impact of the Seventh Pay Commission salary hike. A boost in demand is expected which will no doubt push up inflation. Also crude oil prices have to be watched carefully. A spurt in crude prices will be a spoiler of things and inflation will shoot up again.  The rise in the minimum wages may also lead to cost-push inflation.

The entire world is going through a slowdown and India seems to be the only bright spot with the highest growth rate. To maintain it, the service sector growth has to pick up from its current level and export growth should become more dynamic and boost manufacturing growth in future. The RBI is concerned about the shrinkage in the volume of trade. If exports don't accelerate faster, GDP growth may slacken. If in addition we see the rise of protectionism then India will face more problems on the export front in goods and services.  In any case the high growth rate predicted by the IMF for India should translate itself to greater well-being for all and access to bank credit for small and medium enterprises and women's enterprises also --which will be very important to bring about the much-needed growth with equity. Banks in every village should be operational and people should be able to access loans easily. Banking correspondents are critical links between the rural population and their banks.

As is well known, access to loans is still difficult for poor farmers without adequate collateral. Better rural roads as well as mobile banking should make bank financing accessible to the remote areas. What we need is better infrastructure for banks in villages otherwise access to the much needed credit will be denied to those most in need.

If inflation falls below 5 per cent there could be another rate cut. But cutting interest rates has not been a solution to triggering growth through investment. The entire EU and Japan are having a near zero rate of interest but there are few signs of recovery.  But catering to the needs of our local people, a bank rate cut is welcome at a time when taking loans from banks, apart from hassles of paper work, is not easy for the poorer sections.

India has also to develop a deeper bond market so that municipal corporations which are presently bankrupt can raise money to improve the civic structure of big cities. A network of small and big loans make up the map of banking in India and these have to be connected to the BRICS regional banks that have come up in China for accessing bigger loans for green infrastructure.

The interest rate cut will hurt pensioners and senior citizens whose interest income will diminish, though there will be relief for the takers of home and car loans. On the whole, the bigger picture should be kept in mind and small tinkering of the repo rate should not make much of a big difference.

This commentary originally appeared in The Tribune.

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David Rusnok

David Rusnok

David Rusnok Researcher Strengthening National Climate Policy Implementation (SNAPFI) project DIW Germany

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