Monetary Policy: Yet another reluctant rate cut

The Reserve Bank of India (RBI) made yet another cut in the repo rate, in its mid-quarterly Monetary Policy review. The Cash Reserve Ratio (share of deposits banks have to park with the RBI) was however kept unchanged. As we predicted at the start of the year, the central bank has become increasingly dovish come 2013. Although happy with the government’s focus on curtailing deficits, the RBI is clearly not comfortable with inflation levels. Nevertheless, under pressure to stimulate capital investment and growth, the central bank made a reluctant rate cut.

The repo rate has been cut by 0.25%. The rates for the CRR and the repo now stand at 4% and 7.5% respectively. Consequently the reverse repo rate under the Liquidity Adjustment Facility (LAF) stands adjusted to 6.5%.

How the situation has changed on the ground?

The US has been seeing some improvements in macroecnomic numbers. However, there is still uncertainty with regards to the debt ceiling and certain other temporary appropriations. The euro zone also continues to be plagued by various economic uncertainties most recent being the Cyprus bailout and taxation of bank deposits. Japan is still struggling, and while emerging markets are growing, their pace has slackened.

The Indian economy expanded at a 15-quarter low rate of 4.5% YoY in Oct-Dec 2012 quarter, which is worrying. The services sector, which was usually the bastion of growth, has decelerated to its slowest pace in a decade. Although industrial production in January picked up to 2.4% growth after two months of contraction, the recovery is still weak and a stimulant was required.

On the inflation front, the year-on-year headline Wholesale Price Inflation (WPI) edged up to 6.8% in February 2013 from 6.6% in January. Unfortunately, consumer inflation (CPI) continued its upward trend, touching a high of 10.9% in February 2013 on sustained pressures on prices of food items, especially cereals and proteins.

Going forward..

Export growth is still weak affecting the current account deficit and the fiscal deficit continues to loom large. Investment is key to invigorating growth in the country, and the RBI has tried to improve investment sentiment by cutting interest rates. But, just lowering rates is not the only way to revive sentiment. India needs to continue on a path of fiscal consolidation and bridge supply constraints in order to curb inflation.

More importantly, RBI Governor Dr Subbarao, acknowledged that there is limited headroom to ease monetary policy going forward as supply-demand balances persist. The government has to play a key role in stimulating growth with policy measures. But, with the deficit number hitting a record high, this is going to be a tough rope to walk.

We do not expect the rate cut to have any immediate positive impact on the banking sector in the near term. Pick up in capital investments too will be subject to many other factors besides lending rates.