Why the RBI must lower interest rates? - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks


Login Failure
(Please do not use this option on a public machine)
  Sign Up | Forgot Password?  

Why the RBI must lower interest rates?

Sep 21, 2007

The RBI's frank account of the key challenges that are to be faced by the Indian economy in the coming months, present the rationale for the central bank's guidance of a slowdown in the growth trajectory. But again, it also offers scope for improved performance. Barring supply shocks of the kind brought about by a bad agricultural season, or some natural disaster, the Reserve Bank of India (RBI) expects the real GDP to grow by 8.5% YoY in FY08. It is unequivocal in its stand of controlling headline inflation (as measured by the WPI) to below 5% (currently a benign 3.5%) for the rest of FY08. Global factors like any further hikes from the already high level of prices for international crude oil, so required to fuel India's growth, can also skew the picture. All of RBI's monetary targets for FY08, like bank credit growth of 22% to 23% are based on these premises.

However, a permutation of some of the key factors impacting credit growth based on forward estimations - generates some interesting conclusions.

What lies ahead?
FY91 - FY00 FY01 - FY07 FY03 FY04 FY05 FY06 FY07
Real GDP growth (%) 5.7 6.9 3.8 8.5 7.5 9.0 9.4
Bank credit growth (%) 15.9 21.4 16.1 15.3 27.0 30.8 28.0
Multiplier (x) 4.3 1.8 1.2 2.6 1.6 1.1 1.3
Money supply growth (%) 17.2 15.8 12.7 16.7 12.1 17.0 21.3
Inflation (WPI, %) 5.5 4.8 3.3 5.5 6.5 4.4 5.0
Source: RBI Annual Report 2007

GDP growth
Bank credit, forming 52% of GDP in FY07, has closely traced the growth of the Indian economy in the past. Infact the multiple of bank credit growth to GDP is taken as a lead indicator of the future credit expansion. With a slowdown in the average GDP growth to 8% over the next two fiscals, the slowdown in bank credit is pertinent.

Inflation too plays a crucial role in supporting the growth momentum of the key industrial and service sectors (together about 82% of the GDP). While low inflation would lead to excess money supply and restrict flow of credit to the productive sectors, a shoot up in the same hampers growth of productive sectors for want of capital. Coupled with average 8% GDP growth, the inflation rate of 5% would help the nominal GDP grow by 13% over the next two fiscals.

Credit-GDP Multiplier
The best yardstick of 'productivity', the multiplier, which is nothing but the ratio of incremental GDP (or GNP at market prices) to incremental credit growth, has averaged at around 1.8 times in this decade. The multiplier increases with higher GDP growth and restricted capital flow, while it shrinks with increased credit expansion. Assumption of average GDP growth of 8% and inflation of 6% gives us a multiplier of 1.3 times. However, with this assumption, the incremental bank credit growth falls below the targeted 20% YoY. A low multiplier would therefore be necessary for the RBI to achieve its credit growth targets.

Retail credit - The Joker in the pack!
Thanks to a surge in credit to retail sectors, the multiplier dropped from 2.6 times in FY04 to an average of 1.3 times over the last three fiscals. In FY07, while 36% of the incremental non-food credit was absorbed by industry and another 14% by agriculture, personal loans absorbed 24%. The share of housing loans in personal loans on an incremental basis averaged at 48% over the last two fiscals. The retention of the high growth rate in credit to retail sector, thereby keeping the multiplier below 1.5 times, will be a decisive factor to ensure that the incremental credit growth does not fall below 20%.

How do the interest rates play a role?
Looking back, the reason for the surge in retail credit over the past few fiscals were the low interest rates and an easy monetary policy. The sustenance of the same will be inevitable if the gradual moderation in credit slowdown is to be effected as against a sudden drop. Given that opting for higher inflation would be unaffordable for the central bank due to political and economic factors, keeping the interest rates benign seems to be the only way out. This calls for the RBI to adopt a softer approach in its interest rate policy (though not with the intention of aping its US counterpart). The timing and nature of the same is best left to the seasoned mentors of the monetary policies.

Equitymaster requests your view! Post a comment on "Why the RBI must lower interest rates?". Click here!


More Views on News

Data is the New Oil but It's Also the New Sugar. Here's How to Fight it (Profit Hunter)

Jun 1, 2020

Is too much data hurting your quest for market beating returns?

Quantum Mutual Fund: Hum woh nahi hain (The Honest Truth)

Apr 29, 2020

Ajit Dayal on how the mutual fund industry robs you of your wealth.

This One Trigger Could Turnaround Yes Bank's Stock Price (The 5 Minute Wrapup)

Oct 16, 2019

If Yes Bank manages to do this, it could be the start of a much-needed turnaround for the bank.

Gold could Hit 40,000 Sooner Than Expected (Profit Hunter)

Aug 16, 2019

Domestic gold prices are firing on both engines now. Gold prices could touch 40,000 faster than you could imagine.

3 Rebirth of India Opportunities Are Racing Ahead in These Gloomy Times... (Views On News)

Jun 28, 2019

Tanushree Banerjee shares an update on the Rebirth of India and reveals her top 3 trends...

More Views on News

Most Popular

Why We Picked This Small-cap Stock for Our Hidden Treasure Subscribers (Profit Hunter)

Sep 17, 2020

This leading household brand will profit big time in a post covid world.

My Top Stock to Buy in this Market Selloff (Profit Hunter)

Sep 22, 2020

The recent correction offers a great opportunity to buy this high conviction smallcap stock.

What Do the Charts Say About Buying Smallcaps Now? (Fast Profits Daily)

Sep 18, 2020

Everyone seems to be excited about buying smallcaps now...but is it the right thing to do? What do the charts tell us? Find out in this video...

Can the Nifty Fall to 10,200? (Fast Profits Daily)

Sep 24, 2020

The Nifty has reached an important support level today. If it breaks then we could see further downside.


Covid-19 Proof
Multibagger Stocks

Covid19 Proof Multibaggers
Get this special report, authored by Equitymaster's top analysts now!
We will never sell or rent your email id.
Please read our Terms