By Invitation. Rate cuts to fuel growth

Tight liquidity and anaemic transmission of past repo rate cuts by the Reserve Bank of India (RBI) have been the most binding constraints on lowering borrowing costs. While the RBI cut the repo rate by 25 basis points (bps) in its April 5 monetary policy review, its focus was to enable faster transmission of past rate actions — and rightly so.

Unsurprisingly, the RBI stuck to its 7.6 per cent GDP growth target for fiscal 2017 with no new information to warrant a change in outlook since the previous policy.

The rate cut, too, was not a surprise given the convergence of domestic and global factors that ensured consumer inflation stayed within the RBI’s 5 per cent target for 2016-17. While inflation was lower than expected in February, industrial production was tepid. With a weak economy generating disinflationary pressure, the global sluggishness was a positive for inflation control. A recent RBI survey showed household inflationary expectations tamping down. And by targeting the fiscal deficit at 3.5 per cent of GDP, the government expanded the space for the central bank to cut rates.

The RBI has lowered the repo rate by 150 bps in this rate-cutting cycle that began in January 2015. While market-driven interest rates — on commercial papers and certificates of deposits — fell sharply until November, tighter liquidity has pushed them up again. Base lending rates of banks have come down only 60 bps, limiting the impetus to consumption from lower rates.

However, in the coming months, policy transmission is expected to get better as: 1) the government has cut the small-savings rate, effective April 1, providing more room to banks to reduce deposit rates. This will help lower the cost of funds, a key component in pricing loans; and 2) the shift to the marginal cost of the funds-based lending rate (MCLR) to price loans — from using the average cost of loans — will also bring down lending rates.

With liquidity conditions tight, the RBI’s rate-cut action is expected to gradually take hold. In March, the net liquidity injection was ₹1.9 lakh crore, compared with ₹1.3 lakh crore in January. This is mainly the result of larger government cash balances with the RBI, faster growth in currency with the public (15 per cent on-year), and higher seasonal demand for bank credit (11 per cent on-year). The RBI has announced steps to improve liquidity by: 1) lowering the average ex-ante liquidity deficit in the system from 1 per cent of net demand and time liability (NDTL) to neutrality; 2) reducing the minimum daily maintenance of cash reserve ratio (CRR) by 5 percentage points to 90 per cent; and 3) moderating the build-up of government cash balances with the RBI.

CRISIL believes these steps will trigger a broad-based reduction in interest rates which will mildly support growth. We expect GDP growth at 7.9 per cent in fiscal 2017 (versus 7.6 per cent the previous fiscal) assuming normal monsoon and an unchanged global situation. The pick-up in GDP growth will boost credit growth to 12-13 per cent. The narrowing gap between bank lending and capital market rates, and healthy retail credit growth, will also support an uptick in bank credit growth.

Despite this, the credit growth will be mild, owing to rising gross non-performing assets (GNPA). In fiscal 2017, GNPAs are expected to be higher at 7.7 per cent (compared to 6.8 per cent) with increased slippages from large accounts.

The target of 5 per cent inflation in fiscal 2017 is eminently achievable. The bigger worry, from the perspective of the RBI’s medium-term target of 4 per cent consumer price inflation (CPI), is food inflation. Food, with a weight of over 40 per cent in the new CPI index, has been driving inflation in the past decade. In addition to food-stock management, taming food inflation requires rekindling agriculture via a holistic mix of measures to improve productivity, cut wastage, and develop agricultural markets. So far, we have seen excellent coordination between the RBI and the government on inflation management. The same needs to continue for attaining 4 per cent inflation. The ball is again in the government’s court for bringing food inflation down and keeping it there.

The writer is Chief Economist, CRISIL