What a rate cut will not achieve

Moneylife Digital Team 04 April 2016

The possible rate cut of 25-50bps by RBI is unlikely to stimulate capex as there is a need for complimentary demand side policies, says a research note

The Reserve Bank of India (RBI), in its first bi-monthly monetary policy review for FY2016-17 on Tuesday is widely expected to cut interest rates by at least 25 to 50 basis points. However, the monetary easing is unlikely to stimulate capex now amidst weak demand and there is a need for complimentary demand side policies, say a research note.

In the report, Religare Capital Research Ltd, said, "Going by RBI’s stated preference for maintaining real interest rate in the 1.5-2% range, there is room for 50bps rate cut. However, RBI may cut repo rate by only 25bps in April policy and rather wait for further development on monsoon and 7th Pay Commission implementation while also taking steps to improve transmission."

As per RBI’s latest order books, inventories and capacity utilisation survey (OBICUS), capacity utilization levels continue to remain low at about 70%. External and domestic demand, especially from rural India, continues to remain subdued. Thus, monetary easing is unlikely to spur investment demand, Religare feels.

"FY2016-17 Budget did attempt to address the weak demand conditions by focusing on infrastructure and rural India. However, the wait may be longer. It may ultimately be a policy choice – to induce demand slowly in a low inflationary way leading to a lower but less volatile growth trajectory, or to induce demand in a stronger way, leading to high inflation and higher but more volatile growth path," the report says.

Elaborating the logic behind the possible rate cut, Religare said, multiple factors have converged during the last 30 days that warrant a policy rate cut in the upcoming monetary policy review on 5th April. These include, a sharper-than-expected fall in February Consumer Price Index (CPI) inflation number to 5.2% from a 17-month high of 5.7% in January 2016, the government's decision to stick to the fiscal deficit roadmap in the Union Budget FY206-17 at least on paper, the sharp slowdown in Index of Industrial Production (IIP) post first half of FY2016 and the government’s decision to cut interest rates on small savings and thus strengthen the monetary policy transmission mechanism.

The RBI has stated its preference for maintaining real interest rate (T-Bill rate minus inflation) in the 1.5-2% range. The average real interest rate in FY2016 has been 2.5%. Thus, there is a 50bps room for monetary easing.

However, Religare said, this is dependent on inflation trajectory. The RBI has set an inflation target of 5% by end-FY17. In order to achieve this, core inflation, which has remained sticky at about 5% during the last 12 months, will have to decline from current levels in order to cushion for the gyration in food inflation. The upside risks to CPI inflation is from poor monsoon, 7th Pay Commission implementation, particularly the housing component and a rebound in oil-prices from low sub-$40 per barrel. Inflation expectations are also inching up; as per the RBI’s household inflation expectations survey, 3-month and 1-year ahead inflation expectations edged up in December 2015 quarter.

"Given the upside risks to inflation, the RBI is likely to cut repo rate by only 25bps in April policy and rather wait for further development on monsoon and 7th Pay Commission implementation while also taking steps to improve transmission," Religare concluded.

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