The announcement by RBI Governor Raghuram Rajan to slash the repo rate by 50 basis points has surprised many given his stand, taking baby steps in reducing interest rates so far and strictly focusing on inflation. However, both domestic and external economic situation warranted a growth-inducing big step, particularly when the Government of India is targeting growth rate of 8 to 8.5 per cent when actual growth in first quarter is 7 per cent.
The announcement is in line with the expectation of the government to give a push to revive investment and demand in the economy. Therefore, it is not a big surprise but a right call by Ranjan. Now the repo is at 6.75 per cent, down from 8 at the start of the year, to reach the level of 2011.
As the RBI’s mandate is clearly defined as an inflation targeting approach by the MoU signed by the government and RBI in February 2015, the moderation of consumer price inflation in last few months and the latest figure being 3.66 per cent in August created the space for RBI for a big push.
The present CPI figure, which is well within the suggested inflation targeting of 4 per cent (+ or – 2 per cent), along with lower commodity prices across sectors, except food, created perfect timing for a big rate cut. The commodity prices are not expected to spike in near future, particularly fuel and precious metals which are India’s main imports and used as inputs, given the overall situation in the world market. The commodity prices such as crude oil, metal, chemicals, natural gas etc are turning downward for some time and likely to continue as the largest consumer in the world, China, is slowing progressively.
India’s exports have been sluggish and negative for the last two quarters. The low international commodity prices and resultant input costs have not contributed to growth due to exports contraction. Therefore, giving a push to domestic demand to offset exports contraction is the need of the hour. Domestic demand across commodity class is less than expected leading to under-utilisation (use of less than 70 per cent of capacity) of capacity in the industry. Another indicator which says it all about consumption and investment demand is credit off take.
The credit growth in the last few quarters has been lower than expected in spite of RBI cutting repo rate three times at 25 bps. The reduction of interest rate by 50 bps, total 1.25 bps in the year, is expected to boost both investment and consumer demand. Given the 7 per cent growth in the April-June quarter, pick up in domestic demand is a must if India has to achieve the growth of 7.5 per cent for the current fiscal.
Lower capital cost due to rate cut will certainly give a boost to capital expenditure to companies those are struggling with cash flows and trying to manage their balance sheet. Capital expenditure is at a five year low due to lack of demand and the recent announcement by the RBI is certainly going to help aggregate demand, at least in the short term.
Big sectors
Some of the big sectors such as infrastructure, real estate and housing are expected to benefit from the current announcement. For example, lack of institutional funding, as banks and financial institutions are suffering from high NPAs, to infrastructure and housing sector due to high debt burden will get better and further, it will be backed by interest-induced higher demand.
The rate cut has also come in the right time, just before festive sessions like Navaratri and Diwali, to give boost to consumer demand. Cheaper loans will attract consumers for both borrowing and investment in housing, auto mobile and reality sector on festive occasions.
Housing is a big sector having impact on sectors like construction, metal, cement etc and thereby overall economic activity. The expected increase in low cost borrowing along with the government focus on low and affordable housing policy will play a role in revival of housing sector.
Of course, it all depends on the pace and magnitude of monetary transmission. Monetary policy transmission has been week and comes with a lag. But this time, the response has been quick. For example, the leading public sector State Bank of India has already announced to cut the base rate by 40 bps applicable from October 5.
It’s matter of time that other banks and financial institutions will follow suit given an open and competitive financial sector. So, what seems very clear is that the timely rate cut by the RBI will boost very important capital intensive sectors and thereby revive investment. Earlier, gradual approach of 25 bps rate cut did not bear much fruit as those announcements were on expected lines and banks delayed in passing on the benefits to both consumers and investors.
However, this time, both the government and the central bank are proactive for immediate monetary transmission and addition of 50 bps rate cut to earlier 75 bps rate cut in the year will certainly make visible impact on credit off take, investment, consumer demand and overall growth.
Overall, the RBI’s rate cut is a right decision and completely based on economic merits. In addition to both international and domestic market conditions, the decision of the Fed to postpone rate hike has also helped Rajan to take the big positive step. This certainly adds to positive vibes created by PM Narendra Modi in his recent visit to the USA that India is ready for investment.
In fact, India has pipped China to become the most attractive destination for FDI in the world. However, interest rate is just one of the factors affecting consumers and producers decision. What is necessary is ease of doing business that needs reforms across the board. And everybody knows what these reforms are!
(The writer is Associate Professor, Institute of Economic Growth, Delhi University)