Is a rate cut imminent? - Views on News from Equitymaster

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Is a rate cut imminent?

May 8, 2001

The talk of a cut in interest rates has intensified over the last few days. Bank stocks have witnessed an increase in buying interest. Gilt funds too have turned in a good performance over the last few weeks. Investors would do well to keep in mind that low interest rates are not a forgone conclusion.

  • More on the Indian economy

    There are a number of reasons why interest rates are likely to reduce. One, interest rates in US are on a downtrend. This gives more leeway to the domestic central bank to cut rates without the fear of triggering depreciation in the value of the currency. Adding to this comfort factor is the large forex reserves. Two, structural changes such as a cut in PPF rates have ushered in an environment where lower interest rates are more sustainable. Three, over the years the CRR has been reduced, thus freeing up resources that were previously locked with the central bank. With a clearly stated policy to reduce CRR over the medium term, a lower interest rate environment seems imminent. Another reason for a cut in rates could be that growth in industrial production has slowed significantly. Lower rates could trigger much-needed investment and consumption activity.

    Probably by now you are convinced that interest rates are on the downswing. However, just before making an investment decision, please take note of this statement by the deputy governor of the Reserve Bank of India, Dr Y V Reddy, “Fiscal deficit continues to be extremely important factor in determining the fate of development of the financial market.” Dr Reddy was responding to our question on whether a low interest rate regime would be sustainable in view of the large fiscal deficit.

  • Read interview with DR Y V Reddy

    Consider this. The government alone is likely to borrow in excess of Rs 1,100 bn from the markets. Apart from this, one needs to factor in the borrowings of the public sector units, state governments and other state bodies. This puts a tremendous strain on available financial resources, often leading to a ‘crowding out’ of private sector investment activity. (‘Crowding out’ basically implies that sometimes investment projects are shelved, as interest rates are higher than what is desired).

    It is this competition for funds between various government bodies and the private sector that has lent a degree of stickiness to interest rates. This is what leads us to believe that even though a low interest rate regime is likely, the path to achieving it is unlikely to be as smooth as it is often made out to be. The argument for a rate cut is undoubtedly compelling. But then, so is the threat from the burgeoning fiscal deficit.

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