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25 basis point rate cut likely, but all eyes on RBI’s language

LiveMint logoLiveMint 31-07-2017 Tamal Bandyopadhyay

Speaking on the sidelines of an economics conclave in New Delhi over a weekend in July, Reserve Bank of India (RBI) deputy governor Viral Acharya said the cleaning up of the books of banks was the Indian central bank’s number one priority ahead of cutting interest rates.

This is in sync with his view reflected in the minutes of the June meeting of the Monetary Policy Committee (MPC) where Acharya justified the tolerance of a slightly higher rate of interest as aimed at ensuring that banks “do not find relatively low the hurdle rate for evergreening of bad loans”.

Evergreening typically refers to the practice of giving a fresh loan or a short-term line of credit to a borrower to service the interest of an existing long-term loan.

The facility is routinely renewed, so that the long-term exposure of the borrower technically remains “standard” and is not classified as “bad”.

According to media reports, Acharya had said: “What is required for monetary policy to do its job better is to address the stress on bank (and highly indebted borrower) balance sheets.” In the June meeting, the policy rate was left unchanged at 6.25% even as one of the six members of the MPC strongly pitched for a 50 basis point rate cut. One basis point is a hundredth of a percentage point.

Apart from helping banks evergreen bad loans with cheap money, lower interest rate has another advantage.

Even though most banks are not happy about giving fresh loans for fear of accumulating more non-performing assets (NPAs), they make money by trading bonds when lower policy rate drives down the bond yield. Prices of bonds and yields move in opposite directions.

Treasury profits help banks provide for bad assets. When the government is not in a position to directly recapitalize weak banks because of fiscal constraints, this is a sort of backdoor recapitalization with the tacit help of the banking regulator.

If these are arguments against a rate cut, there are equally strong reasons for one.

Inflation has steadily been declining in India. Food inflation has been falling steeply and overall consumer price inflation which was 6.1% in July 2016 dramatically dropped to 1.54% in June 2017, much lower than not only what analysts had expected but also the RBI’s target band (2%-6%).

Indeed, the retail inflation bottomed out in June and, from now on, it can only rise—but it may end the fiscal year with around 4% if the monsoon continues to be normal and international crude prices remain benign.

At the last policy meeting, RBI cut its inflation forecast to 2.5-3.5% in the first half of 2018 and 3.5-4.5% in the second half. The Asian Development Bank’s latest estimate puts India’s average inflation in fiscal year 2018 at 4%, some 70 basis points lower than its estimate at the beginning of the year.

Inflation based on the wholesale price index, or WPI, slipped to an 11-month low of 0.9% in June, with food inflation remaining negative and prices of manufactured items rising at a weak pace. Wholesale inflation has been on a downward trend since February.

An inflation targeter central bank does not look at the inflation of today but that of the future. Even then, clearly, the space has been created for a rate cut. The question is, how much?

The market has priced in a 25-basis point rate cut but a few analysts feel RBI could front-load it and go for a 50-basis point cut. If RBI is looking for a 1.5-2% real interest rate (the policy rate or one-year treasury bill yield minus the year-ahead projection of inflation) there is scope for a deeper cut but I would like to believe there could be a 25-basis point rate cut.

The chances of holding on the current policy rate are slim and at the same time RBI may not go for a 50 basis-point cut unless it is absolutely sure about the inflation path.

The food price deflation will retreat slowly; there are uncertainties on the impact of the goods and services tax or GST-related price changes (it could lower inflation) and the second round effects of the hike in housing rent allowance by the 7th Pay Commission will start playing out from July.

RBI also needs to consider global uncertainties which have risen since the MPC’s June meeting.

The European Central Bank held interest rates and asset purchases steady at its last meeting but it is expected to decide in September whether to begin tapering—slowing down the pace of the current bond-buying programme of €60 billion ($69 billion) a month before it expires in 2018.

The US Federal Reserve, too, could begin trimming assets acquired through its massive monetary easing programme; it could start initially at a slow pace of $10 billion per month.

The announcement could be made as early as the Fed’s next meeting on 20 September, and become effective from 1 October. The so-called quantitative easing or large-scale purchases of assets such as US treasuries- and government-supported mortgage-backed securities launched in the wake of the financial crisis in 2008 led to the rise in the size of the Fed’s holdings from $900 billion to $4.5 trillion.

While the Fed kept its policy rate unchanged in the July meeting, the Bank of Canada has raised the target overnight interest rate by 25 basis points to 0.75%, its first rate hike in seven years, and its statement was more hawkish than many had anticipated. The Australian central bank too has turned hawkish, even though it does not want to raise policy rates soon.

Against this backdrop, RBI will find it difficult to opt for a 50-basis point rate cut; it could rather decide on a 25-basis point cut, bring the policy rate to 6%, and wait and watch how things unfold globally as well as on the inflation front to decide on the timing of another rate cut, if there is scope.

More than the rate cut—which is almost a given—the focus will be on the language of the monetary policy statement: is it the last of the rate cuts for the time being or will the Indian central bank have space for another round later this year?

Economic growth has slowed for four successive quarters and the private sector is unwilling to invest; the tardy bank credit growth is a testimony to that.

Whether a rate cut will revive demand and encourage corporations to make investments is another story. The Indian banking system is not known for quicker monetary transmission.

Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. He is also the author of A Bank for the Buck, Sahara: The Untold Story and Bandhan: The Making of a Bank.

His Twitter handle is @tamalbandyo.

Respond to this column at tamal.b@livemint.com

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