On 7th August 2019 the Reserve Bank of India (RBI) released its third bi-monthly monetary policy statement announcing a reduction in the repo rate by 35bps to 5.40%. Accordingly, the reverse repo rate, marginal standing facility rate and the bank rate also stood revised at 5.15% and 5.65% respectively. The RBI’s decision does not come as a big surprise as this reduction will assist in achieving the medium-term target of Consumer price index (CPI) of 4%, which currently stands at 3.18%. While maintaining the accommodative stance, the RBI is ensuring that the policy rate revision support the economic growth of the country.
Why 35 bps cut??
The MPC is of the view that supporting domestic economy growth is of the utmost priority. Our economy is majorly reliant on domestic market cues and therefore a rate cut to further the goal stabilizing domestic demand and supporting investment activity is, if not obvious, practical. The decision to go with a 35 basis point cut instead of a 25 basis point is based on three major factors, firstly a reinforcement of past rate reductions and thus ensuring a quicker transmissions of real interest rates and secondly, to inject or flood the system with surplus liquidity and thirdly, to make substantial effort at closing the rising output gap. There was consensus that a 25 bps reduction might not be a big enough push in the right direction and an unconventional 35bps might have a bigger and much needed impact on the economy.
The repo rate cut in the latest series of reductions was mainly justified based on the following four factors:
Excluding food and fuel inflation, before the chain of rate cuts had begun in the first bimonthly monetary policy, the inflation was way off course from the medium-term target of 4% and the long-term target of 6%. The uptick in inflation can be witnessed from the last time the MPC met to reduce the repo rate by 25bps.
The increase in food inflation is still below the devised target and is also the main reason for a 12-month forecast of headline inflation being below the 4% medium term target.
The agriculture sector will predictably witness a short-term upward momentum of prices due to two reasons:
Flooding of several agriculture-based regions of the country affecting their capacity to harvest or even store produce.
Drought prone regions, mainly in the central states are currently facing yet another year with scanty rainfall, reducing supply and increasing short term prices.
Overall, the south west monsoon witnessed 6% below long period average (LPA) Rainfall and conclusively the area sown under Kharif crops was 6.6% lower compared to a year ago.
We have also observed the simultaneous increase in food inflation with every subsequent rate cut in fig 1.1. This forms the basis for further action to reduce rate cuts in response to relatively low food inflation.
Overall, to achieve the medium-term target of 4% for headline inflation, a rate cut is justified seeing as how inflation has responded to the previous rate cuts.
According to the observations made by Monetary Policy Committee (MPC) members, indicators from several surveys and other sources emit the message that aggregate demand has been weakening which has also affected the labor market growth, the capacity utilization of present capital and resources has increased due to absence of investments, growing inventories in several major sectors including housing and automobiles combined with weak pricing power of corporates have made the case for a deteriorating domestic economy in the next 12 month horizon.
In the rural economy, tractor and motorcycle sales, considered good indicators of rural demand, have continued to decrease. While in the Urban economy, passenger vehicle sales have dipped to unprecedented levels and raised concerns across the county. These facts hint that there is a long haul of corrections before the overall economy bounces back.
This situation still prevails at the time of August 2019 MPC meeting and with further dip in consumer confidence in the economy due to several tense political situations and extreme disaster conditions in major states, a rate cut is if not necessary, highly important to boost consumer sentiment and private investment. In the long term, a consumer driven boost might be expected as a result after the 12-month period.
Global Economic Outlook:
The MPC has raised concerns on the ongoing trade war between the US and China as well as the ongoing sanctions on Iran. Reports of a rising output gap from central banks across the globe proves that International trade activity has witnessed escalating instability. As we go to print this heightened concern has only risen due to a dim outlook of a US – China trade war. The international trade activity has witnessed extreme instability in the last couple of months as several central banks across the globe report a rising output gap. The Indian exposure to several strong corrections in the global market is minimal as it isn’t a key player in the global supply chain. But, a lack of exposure to the global supply chain might not be able shield the domestic economy if a full-fledged trade war were to take place.
As per the Economic Cycle Research Institute’s where 20 country Long leading Country’s Global Leading Manufacturing Index* growth has been low in past seven years this depicts a gloomy global scenario. As a response focus of policy on domestic investment and consumption seems to be a more viable option.
The MPC is looking to address growth concerns by boosting aggregate demand, especially through private investment. For this, the RBI aims to provide relief to the NBFC sector through 2 key policies: –
RBI increased the ceiling for a bank’s exposure to a single NBFC from 15% to 20%
Bank lending to registered NBFCs for on-lending to agriculture up to Rs 10 lakh, loans up to Rs 20lakh (up from Rs 10lakh) for MSME sector and housing loan up to Rs 20lakh per borrower have also been classified as priority sector lending.
Through these 2 policies, RBI is nudging banks to ensure NBFC’s liquidity needs are adequately addressed.
To address liquidity concerns, the RBI reduced the risk weightage on consumer loans from 125% to 100%, meaning that banks now have more capital to lend out (as they can now keep aside lesser capital as risk on loan) which can result in lower interest rates on personal loans and subsequent boost of consumer demand. Given that only 29 bps of the 110 bps rate cut has been transmitted by banks, a bigger liquidity push is needed for the banking system
Posted By: October 2, 2019
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