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Implications of the rate cut - Views on News from Equitymaster
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  • Oct 23, 2001

    Implications of the rate cut

    The Reserve Bank has taken everyone by surprise. The much higher than anticipated cut in CRR and Bank Rate will go a long way in supporting economic recovery in the country.

    Fundamentally, lower interest rates (assuming that banks follow the RBI's signal), which imply a lower cost of money, make it more attractive for people to borrow for the purposes of investment and/or consumption.

    From the plight of the domestic capital goods sector it is evident that investment activity has been very sluggish for many months now. Even non-oil imports have not indicated any signs of buoyancy. In this light, a cut in interest rates will boost investment activity as the cost of setting up new facilities or undertaking expansions/renovations reduces. And in an environment where companies may not be in a position to raise funds from the stock markets, the RBI's initiatives will surely come as a relief.

    From the consumption point of view, the rate cuts are equally important. Take automobiles for example. Most buyers of automobiles prefer to get financing from finance companies / banks. As the cost of funds reduces for these companies/banks, so does the rate at which they lend to buyers. This makes a purchase seem relatively more attractive to the buyer. The same holds true for consumer goods and housing (an investment, actually) among others.

    The RBI has been behind the curve as far as interest rate cuts are concerned in the wake of a global slowdown. Probably the threat of higher oil prices (more inflation) was a key hurdle faced by the regulator. However, given the present environment of low inflation rates, adequate food stocks and tolerable crude oil prices probably spurred the RBI into such an unprecedented move.

    Although a rate cut is beneficial for the economy, one needs to take into account several factors before determining its exact impact. First, the banks are already flush with funds in view of the limited investment opportunities. Indeed, banks continue to park a large part of their funds in government securities. Second, a domestic as well as a global slowdown has hit the corporate sector. Therefore, with little incentive to invest in new capacities, the demand for funds has anyways been limited. In such a scenario one has to look at the rate cut as one of the enabling tools for economic recovery and not 'the' tool.

    One of the bigger beneficiaries of the rate cut will be the Government of India, which is a very large borrower in the domestic markets. Lower rates will, in a small way though, contribute to lowering the fiscal deficit by reducing the government's debt burden.

    With the most recent cuts in CRR and Bank Rate the RBI has underscored its task to steer India to a regime of low interest rates. This should be very good news for the Indian Corporates, who have been complaining about lack of competitiveness in international markets given their high cost of capital.

    To conclude, the RBI has done its bit to jerk the economy out of its state of sluggishness. Now its upto the government, corporates and consumers to respond to this challenge.

    For full coverage of the Monetary and Credit policy, please click here.



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