The RBI’s view on the economic situation and its policy response is probably the most critical element today as it shows, in a way, the possible way forward. The central bank has to contend with three major elements when making any announcement.
First, it has been raising interest rates to combat inflation, and the number is still not really in a comfort zone to actually hasten rate reduction, even though it was done in April. In May, inflation was well over the 7 per cent mark when a central bank should typically consider increasing interest rates. Can it really change its stance now which may indirectly be an acceptance of the fact that interest rates do not really affect inflation?
Second, the overall growth scenario appears to be not-so-good, with GDP growth number for FY12 being low and industrial growth for April being flat at almost nil. Can lowering interest rates spur growth now?
Third, overall sentiment is low which has been dampened further by the possibility of a rating downgrade by S&P. Also there is nothing much happening in terms of policy changes. Therefore, monetary easing to boost sentiment may not be a bad idea. What will the RBI do?
There are basically two choices for the RBI: lowering rates or the CRR, or both. From the theoretical perspective, lowering interest rates may not help except raise sentiment. The initial interest rate cut announced in April has lowered base rates, but there has been no pick up in credit, which means that merely because rates are low people will not borrow more. There are three reasons for this. The first is that this is typically the slack season when demand for credit is low. Second, overall demand conditions are more important for spurring credit growth, and this is lacking now. Third, expectations of interest rates works are more effective when it comes to taking borrowing decisions. In case industry or infrastructure is expecting a series of rate cuts, investment plans may be held back to a later date.
Therefore, lowering rates on its own may not really help to push up credit. CRR cut has also been spoken of recently. A CRR cut of 1 per cent can release around Rs 60,000 crore into the system. The issue is whether or not there is need to ease this rate further. Looking at the progress of banking indicators during the financial year so far for the first two months, it appears that banks have a surplus of Rs 40,000 crore to Rs 45,000 crore based on incremental deposits and incremental credit and investments. Further, they are borrowing around Rs 80,000 crore from the repo window regularly on a daily basis, which has become a new norm. The RBI has put in around Rs 70,000 crore through open market operations (OMO) purchases to ease liquidity. Therefore, there is a strong case for leaving it unchanged.
Also it was observed in the past when the CRR was lowered, banks did not really lower their interest rates and the released money got absorbed into the system and the liquidity deficit, which is reflected in repo borrowings, was back to normal. Therefore, a CRR cut may not really help to change monetary conditions even if it is implemented. But a CRR cut is definitely good for banks as it adds to their profits. CRR funds today do not earn any income and any release of such resources would mean a minimum return of 8 per cent which is good for them.
The view here is that while no action looks appropriate, 50 bps cut in repo rate will be useful to raise sentiment, which is required today. This will improve economic environment as there will be further expectations of rate cuts in the months to come. Anything lower than 50 bps may not really be strong enough to raise this sentiment as we are talking more of psychological effect rather than actual decline in interest rates across the board.
Therefore, the call which the RBI is taking will be critical because the options are open to the monetary authority and there are strong and compelling reasons on both sides. The RBI’s decision will decide how it looks at the state of growth, inflation and liquidity.
The author is Chief Economist, CARE Ratings.
The views expressed are personal