The story so far: The Reserve Bank of India (RBI) lowered the repo rate to 5.75% in the Monetary Policy Review in June. This was a level last seen nine years ago. Despite three rate cuts aggregating to 75 basis points in this cycle beginning February, economic growth has failed to pick up and, in fact, has been slowing down even more, There is clamour for another big cut from the RBI in the upcoming monetary policy announcement this week. This is because the transmission of the earlier cuts by banks to borrowers has been poor. By the RBI’s own assessment, only 21 basis points have been passed on to borrowers by banks in this cycle.
What are the repo and reverse repo rates?
The RBI uses the repo rate to influence the interest rate structure in the economy and to manage inflation. Technically, the repo rate is the rate at which commercial banks would borrow from the RBI, and the reverse repo is the rate of interest they would earn when they deposit funds with the central bank.
What is the stand worldwide as far as governments are concerned on cutting rates?
The traditional argument is that the lower the interest rate, the better for businesses as it brings down the cost of capital, making investments more attractive. Any government would love this as the country would then draw higher investments leading to higher growth and more job creation. Governments abhor higher interest rates as, theoretically, these push up project costs and keep investors away.
A case in point is U.S. President George H.W. Bush’s election loss in 1992 to Bill Clinton. The former President actually pointed fingers at Federal Reserve chairman Alan Greenspan as the reason for the defeat. The argument was that had Mr. Greenspan lowered rates, it would have made the economic recovery that the U.S. was going through more visible and hence (purportedly) leading to a re-election of Mr. Bush.
One view on this tug-of-war is that the government of the day typically has a relatively short-term view when it comes to growth but that as an institution, a central bank has the long-term view where low inflation would eventually lead to high growth scenarios.
In this context, nothing comes more quickly to mind than the tussle between P. Chidambaram as Finance Minister and Duvvuri Subbarao as RBI Governor. Despite the best attempts of the government to get the RBI to cut rates, and thus stoke growth, Mr. Subbarao insisted on higher rates in order to keep money supply and inflation low. In his book, Who Moved My Interest Rate?: Leading the Reserve Bank of India Through Five Turbulent Years , the former RBI Governor makes this very point: that to experience sustained high growth, a low-inflation scenario is a pre-requisite.
This view is supported by a paper, ‘Reconsidering Monetary Policy: An Empirical Examination of the Relationship Between Interest Rates and Nominal GDP Growth in the U.S., U.K., Germany and Japan’, published in 2018 in the journal Ecological Economics . The authors, Kang-Soek Lee and Richard A. Werner, found that nominal interest rates are consistently positively correlated with growth.
A central bank also keeps an eye on the fiscal deficit maintained by the government. A high fiscal deficit usually makes it difficult for the central bank to rein in inflation, hence causing it to be hawkish and raising interest rates. The late economist and former RBI Deputy Governor Subir Gokarn’s was a voice that was constantly egging the government of the day to keep the deficit under control.
Why aren’t Indian commercial banks passing on the RBI’s rate cuts to consumers quicker?
Deposits from the public form a chunk of funds that commercial banks use to lend to borrowers. Deposit rates have remained high; only last week, the State Bank of India lowered its rates citing improved liquidity. If deposit rates remain high, then the cost of funds for a bank remains high no matter where the RBI pegs its repo rate. Deposit rates have remained high for two reasons. One, competing interest rates in the government’s small savings schemes have remained high — even after a cut in late June, the Public Provident Fund and the National Savings Certificate yield 7.9%. Compare this with the 6.8% or so that one would get at SBI, the nation’s largest bank.
The other reason that deposit rates have remained high is the liquidity crunch triggered by the sudden inability of the non-banking finance company IL&FS to pay back loans since last September. The RBI intervened to infuse liquidity soon after but these interventions were not enough.
However, the liquidity position has improved in the last two months following consistent market operations by the RBI under its new Governor Shaktikanta Das. This is reflected in the falling yields on government securities. The environment is, thus, conducive for banks to pass on the benefit of lower interest rates to borrowers.
Will lower rates spur economic growth?
Capital is one of the three main factors of production, which are critical to the growth of a commercial entity, the other two being land and labour. But capital is only a necessary, not sufficient, condition. Land, unless allocated by the local government, is too costly for investors seeking to set up shop. On labour, even if adequate hands are available for a job, the skill quotient is still low. Training graduates to be job-ready is a form of tax that companies pay. Also to be taken into account is the market environment and demand. If end users are seeing lesser money in hand than earlier, demand will certainly be impacted.
Therefore, in an environment where the other factors of production are not favourable for an investor, low interest rates by themselves may not prove attractive enough. Any revival of economic activity will be contingent on joint efforts by the government on the fiscal front to stimulate demand, and the RBI, to keep interest rates low.
A rate cut in the upcoming monetary policy announcement this week has to be backed with some positive measures from the government. To hope that a rate cut will suffice to re-ignite economic activity would be naive.
