RBI's Annual Policy statement - clear signals for lower interest rates

As part of its Annual Policy Statement for the financial year 2009-10, the Reserve Bank of India (RBI) today cut repo and reverse repo rates by 25 basis points (0.25%) each. Post the cut, the repo rate now stands at 4.75% while the reverse repo rate stands at 3.25%. With these cuts, the RBI has delivered 425 bps in cuts to the repo rate and 275 bps to the reverse repo rate since the rate-cutting cycle began. RBI has decided to keep the CRR unchanged.

The clear aim of this statement is to prod the banks into lowering interest rates further. While the lending rates ashowing signs of downward stickiness, RBI feels that the banks have room to reduce rates, given that they are more willing to park a large plus of their surplus with RBI.

However, I am not convinced that these measures will actually lead to increase in lending activity. It should be realized that credit flow is as much dependent on the rates as on the sentiment (for both the borrowers and lenders). The drastic fall in domestic private demand and general uncertainty about the economic environment will impact both demand and supply of credit. The lenders are clearly wary of the conditions and have become much more risk averse than they earlier were. Case in point is the abysmally low incremental credit deposit ratio in the last quarter. Actually, the banking system is flush with liquidity with the banks preferring to park huge cash balance with RBI at the then reverse repo rate of 3.5%. Would a 25 basis point decrease in the reverse repo rate change the scenario? Quite unlikely.

What is also important to note is that, all these rate reductions are not percolating down to appropriate reduction in lending rates, especially for longer tenure. Given the huge borrowing programme of the government, there is a possibility of rates being under pressure at the long end of the curve. What is important is to go for some quantitative easing as well (cut in CRR), so that the rates are not under pressure to move up as the borrowing programme starts in full swing after the new government comes in place. Also, many banks have raised high cost fund from the market a few months earlier. These will reduce the banks’ ability to drastically reduce the rates in response to these policy stimuli. Although some banks have reacted by reducing rates immediately after the policy announcement, a large general reduction is not in the offing.

Even on the inflation front, it is quite clear that the benign inflation has a lot to do with high base effect. In fact, we are actually experiencing a situation where the inflation rate is falling while the index is rising. Of course the base effect will imply that inflation will remain benign for some more months to follow, but thereafter, it will rise. However, we are unlikely to see runaway inflation going forward given the current global recessionary situation. My hunch is, it will be between 4 to 4.5% by end of this financial year. Nevertheless, the current near zero inflation is unlikely to impact RBI’s interest rate decisions. Their monetary policy stance will solely be aimed at kickstarting the economy while allowing the previous policy stance to play out fully.

The future movement of the economy will be dependent on coordination between monetary and fiscal policy. That the economy needs fiscal stimulus to be back on track is beyond question, given the substantial reduction in private demand. That will, to a certain extent improve the expectations going forward. At the same time, there has to be a substantial quantitative easing alongwith further rate cuts to force the banks to bring down the rates to a more affordable level as well as actually make them go out and lend. Only then will we see a virtuous cycle playing out.