The RBI takes a bold step

The much-awaited policy rate cut by the Reserve Bank of India has materialised.

After an assessment of domestic and external economic conditions, the central bank has decided to reduce the policy repo rate under the liquidity adjustment facility (LAF) by 50 basis points, from 7.25 per cent to 6.75 per cent, with immediate effect. What is surprising is the size of the reduction in the rate.

Instead of following the baby steps of the past, the RBI has been bold enough to cut down the rate by 50 basis points, instead of 25 basis points, to stimulate the economy. Interest costs constitute a small proportion of the total costs of production of manufactured goods, as revealed by company finance studies. But they are important from the point of view of profitability of manufacturers.

In the context of underutilisation of capacity and building up of inventories, it will be a relief to the corporate sector if the rate reduction is passed through to them. But the evidence so far has not been satisfactory. Commercial paper and corporate bonds have reflected the policy rate cuts of the past. However, banks have not passed on fully the 75 basis point cut in rates in January-June this year. The median base lending rates of banks have fallen by only 30 basis points despite “extremely easy liquid conditions”, to cite the RBI. But banks have been quick to reduce the deposit rates in line with their past practice!

Insofar as there is surplus liquidity, banks have no need to approach the RBI for repos. They can utilise their resources raised through deposits and other means. So, if deposit rates are reduced, does it not stand to reason that they effect corresponding cuts in their lending rates irrespective of whether they access central bank finance or not?

The net result of the ‘accommodative stance’ of the RBI is that bank profitability has gone up. It is not clear how the problem of pass-through can be solved by working with the government, as mentioned in the statement, unless lending rates are regulated directly or indirectly going against the spirit of liberalisation of the financial sector.

The RBI says: “As a result of still tepid aggregate demand, output price growth is weak, but input material costs have fallen further, leading to an increase in margins for most producers.” It is a moot question whether the policy rate reduction will accelerate growth when demand conditions are tepid.

Though the central bank refers to disinflation there is no reference to the high levels of prices of commodities and housing. In fact, if there is a pass-through of the rate reduction, it can give a fillip to the housing sector with a fall in EMI rates. But the prohibitive cost of apartments, especially in cities, precludes any general rise in the demand for housing.

The government’s low-cost housing schemes, if carried out on a large scale, can give a fillip to a number of related industries. In the Input-Output or Inter-Industry Tables for the economy, the housing sector is a major one with large spread effects on the other sectors such as cement, steel, labour, etc.

The statement says: “Since our last review, however, external demand conditions have turned weaker, suggesting a more persistent drag from lower exports and cheaper imports due to global overcapacity. This contributes to continuing domestic capacity underutilisation, decelerating new orders and a rising ratio of finished goods inventories to sales.”

Considering the substantial depreciation of the Indian currency in the forex market it is not clear how imports have become cheaper. The favourable effect of the lowering of oil price has been nullified by the depreciation of the rupee. One wishes the statement threw some light on the developments in the forex market without taking any stand on the right exchange value.

Generally, any academic discussion of the effects of changes in the value of currency is restricted to imports and exports. But there is a third dimension, the servicing of external debt, that is not reckoned with. Ceteris paribus , when the domestic currency depreciates, the country has to export even more in physical terms to earn every dollar than before. It is the real burden of debt. Per contra , the appreciation of the currency is favourable to debt servicing.

In the course of interaction with the press, the governor gave the impression that the Fed decision on interest rate was not the central issue in deciding the policy. But in the bimonthly policy statement of August, the RBI indicated that further monetary policy accommodation will be conditioned, inter alia , by possible Federal Reserve actions. (This is quoted in Para 12 of the current policy statement.) There is no getting away from the fact that in an integrated global financial system the actions of the developed countries impact on the fortunes of the less developed ones. The accretion to reserves of India has been facilitated by the low interest rate regime of the developed countries. This is the time for the RBI to strengthen its reserves by tapping on the massive wealth of NRIs in foreign countries. A few years ago it was reported to be $100 billion. It may be much more now.

Indian banks should be encouraged to mobilise NRI deposits in a massive way by liberalising whatever constraints there are in the policies relating to CRR, SLR and interest rates. It will also help in stabilising the value of the rupee and arresting further deterioration in the exchange rate.

The writer is a Mumbai-based economic consultant