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Will RBI Cut on Repo Rate By 50 Bps Impact The Economy?

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Will RBI Cut on Repo Rate By 50 Bps Impact The Economy?

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Published : Wednesday, 14 October, 2015 10:33 AM

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Will RBI cut on repo rate by 50 bps impact the economy?

In its bi-monthly monetary policy review on September 29, the Reserve Bank of India (RBI) cut its benchmark repo rate by a massive 50-basis point. While the industry and markets expected the monetary regulator to go for a 25-basis point rate cut, the 50-basis point rate cut surprised even the biggest optimists.

That is because the RBI has already thrice cut interest rates this time, and RBI governor Raghuram Rajan’s recent statements barely gave away any hint of a major rate cut and indicated cautious optimism. In his August policy review, Rajan had maintained that future cuts would be subject to inflation and playing out of uncertainties on that front, monsoon, and action of the U.S. Federal Reserve.

Nonetheless, Rajan’s decision has brought cheers ahead of the festive season and more importantly, liquidity infusion in the markets due to reduced interest rates could boost economic growth. A general sense of optimism was evident in the financial markets before the RBI’s decision, with the benchmark 10-year government bond reportedly dropping by five basis points in the latter half of September.

But, the biggest factor that strengthened Rajan’s decision is inflation, which appears to be well-under control. The WPI has hovered in the negative zone for 10 months in a row now, while CPI data for July and August remained below 4%, which is lower than RBI’s indicative trajectory of below 6% before January 2016. The continued downward trend in WPI seems to have provided the relief to policymakers. The trend may change as the base advantage wanes in coming months. Despite that, food inflation likely will remain in the regulator’s comfort zone for now.

Most importantly, there is a limit to which RBI’s monetary policy can rein in food inflation, as a lot of volatility in the prices is a result of inefficient supply-chain management. Without sweeping reforms and investment in the sector, food prices particularly of fruits and vegetables will remain tied to systemic pressures.

The case for interest rate cut became strong because global economy is reeling under deflationary tendencies due to the crash in commodities prices. This is directly related to the slowdown in Chinese economy and excess capacities in commodities dependent economies. The commodities prices may further crash if China devalues the yuan and have a severe impact on the commodities market and goods around the world. RBI needed to intervene to prevent deflationary tendencies overwhelming the Indian economy.

While Rajan remains worried about the United States Federal Reserve going for a rate hike sometime later this year, the RBI has seized the opportunity to maneuver rates and let markets in India settle down. The Federal Reserve raising interest rates is certainly going to have a contagion effect on the global economy, including India. The Fed deferred rate hike last month because it would have shaken currency markets in emerging economies already reeling under Chinese yuan devaluation. But as recent reports indicated U.S. Fed may have to bite the bullet. And whenever that happens, equity markets will be affected with potential outflow occurring.

A major factor that could have prevented the RBI to not go for a rate cut could have been below normal monsoon and its impact on agricultural production. A bumper harvest improves rural market sentiment even though the share of agriculture currently is less than 20% of Indian GDP.

On the contrary, a poor agricultural production plays a dampener, particularly ahead of the festive season. That’s because the sector still accounts for more than 50% of jobs in rural India and engages a majority of the workforce.Low harvest could affect prices as with India’s poor supply-chain dynamics, the problem is only going to exacerbate.

Nonetheless, the prospect of poor agricultural output has not deterred the RBI and a lower interest regime should help boost investor sentiment and ease the flow of finance in manufacturing activity. This will, in turn, create jobs and reduce pressure on agriculture sector, which is plagued with the problem of disguised and seasonal unemployment. A higher interest rate regime eats into earnings and reduces net profitability of businesses, which reduces risk-taking ability.

With that said, creating a positive macro-economic environment and pushing the factors of growth is not RBI’s responsibility alone. As it currently stands, the manufacturing needs to enhance its capacity utilization from the existing 70-71%. The government too needs to do more than on reforms front and cutting down wasteful subsidies and expenditure.

There is a limit on pump priming the economy by the RBI. The Modi administration’s one year has not resulted in big-ticket reforms. For creating positive economic sentiments, both the RBI and the government have to take collaborative steps.

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