The Reserve Bank of India (RBI) surprised markets with a 25 basis point reduction in interest rates on Thursday and signalled it could cut further, amid signs of cooling inflation and what it said was a government commitment to contain the fiscal deficit.
While the early rate cut move was unexpected, aggressive reductions in interest rates have been seen as likely over the course of the coming year to help India’s economy out of a rut, with growth rates struggling to recover from their weakest levels since the 1980s.
Tumbling oil prices and lower food costs have hardened speculation that more reductions in rates will follow, as recent data showed subdued consumer and wholesale price increases.
Acting ahead of a scheduled RBI policy meeting on February 3 and the government’s annual budget statement in late February, the RBI cut the repo rate – its key lending rate – to 7.75 per cent from 8.0 per cent, where it had been for the past year.
As a result, the reverse repo rate, the rate at which the RBI drains excess liquidity from the banking system, also moved down by 25 basis points to 6.75 per cent.
“This demonstrates RBI’s confidence in the evolving inflation outlook and it shows that they are putting faith in government’s fiscal consolidation plan,” said Radhika Rao, economist at DBS Bank Ltd.
Investors saw RBI Governor Raghuram Rajan putting India on a new easing cycle, as the former International Monetary Fund chief economist ordered his first rate cut since being appointed in August 2013.
Finance Minister Arun Jaitley, who earlier this week had said the time was right for lower rates, welcomed the cut and said it would help revive capital investments.
The early RBI rate cut now puts the onus on the government to make credible efforts to contain the fiscal deficit while pursuing policies aimed at boosting investment and improving infrastructure to fire up the economy.
In its statement, the RBI said “high quality” fiscal consolidation and reforms to power, land, minerals and infrastructure would be “critical” to more cuts.
A text of the RBI Governor Raghuram Rajan’s statement on rate cut
The stock market was the second best performer in Asia last year in dollar terms, due to investors’ hopes that Prime Minister Narendra Modi would push reforms needed to unlock India’s growth potential following his landslide election last May.
India has posted sub-5 percent growth rates in its previous two financial years, levels far too slow for a country with its demographic challenges.
SUBSIDING INFLATION PRESSURES
Data released on Monday showed retail inflation rose to 5 percent in December — below the 5.4 percent annual rise predicted by a Reuters poll. The RBI expects retail inflation will hit 6 percent in March and targets a level of below that from January next year.
Some analysts believe Rajan may have come under pressure from the government to lower interest rates sooner than he would have ideally chosen.
“This is a surprise move in the middle of the war on inflation,” said N.R. Bhanumurthy, a New Delhi-based economist at the National Institute of Public Finance and Policy.
“I am very surprised because it goes against the whole current governor’s philosophy that monetary policy should be predictable. It shows the governor is very pragmatic and can look at his own position and can change.”
Key for markets now will be how quickly the effect of Thursday’s cut can boost consumption and investment.
The rate cut pushed the benchmark 10-year bond yield to 7.65 percent, down 12 basis points on the day and its lowest level since July 15, 2013, while stocks rallied, with the NSE index gaining some 2.5 percent.
In the overnight indexed swap market, the one-year rate dropped as much as 13 bps to 7.50 percent, its lowest since July 15, 2013, which traders said priced in an additional 100 bps in rate cuts.
The partially convertible rupee gained to as much as 61.6450, its strongest level since Nov. 17.
Banks are likely to lower lending rates as a result of the RBI action, but company bosses warned a 25 basis point rate cut would not by itself get the economy growing, with many manufacturers running with high levels of spare capacity.
“The real effect at 25 bps is not going to be very much, however, it is the start of a cycle,” said VS Parthasarathy, chief financial officer at Mahindra & Mahindra, India’s top utility vehicle maker.
“Sometimes a stimulus is all about giving a cue… this is a cue.”
Check out the reactions to the poll on RBI rate cut we asked on January 14, 2015:
RBI surprises with rate cut
(PTI) Shedding his hawkish stance, Reserve Bank Governor Raghuram Rajan today sprang a surprise by cutting interest rates by 25 basis point a move that is likely to result in cheaper home and auto loans.
Reacting to the development, the BSE Sensex soared by over 650 points while NSE Nifty rose by over 194 points in the afternoon trade.
The rate cut ahead of a scheduled RBI policy meeting on February 3 will result in “more money in the hand of the consumers,” Finance Minister Arun Jaitley said, while bankers said it was a “movement in direction of interest rate cut.”
Rajan, who had focused on quelling inflation since taking office in September 2013, lowered the benchmark repurchase rate to 7.75 per cent from 8 per cent, the first reduction since May 2013.
As a result the reverse repo rate, the rate at which the central bank drains excess liquidity from the banking system, also moved down by 25 basis points to 6.75 per cent.
Consumer-price inflation will probably be below the RBI’s target of 6 per cent by January 2016, Rajan said.
“Reduction in the rates is a positive development. It will lead to more money in the hand of the consumers and greater spending. It’s positive for the Indian economy,” Jaitley said.
“It will certainly help in reviving investment cycle that the government is trying to restore,” he said.
While SBI Chairman Arundhati Bhattacharya said the country’s largest lender “will look at how and when base (lending) rates can be cut”, ICICI Managing Director and CEO Chanda Kochhar said it was “movement in the direction of interest rate cut.”
RBI rate follows decline in inflation as well as the commitment of the government to stick to the fiscal deficit target of 4.1 per cent of the GDP in the current financial year.
Rajan had during the previous monetary policy review on December 2 hinted at a possible easing in rates early in 2015, including outside of planned meetings.
“These developments have provided headroom for a shift in the monetary policy stance,” the RBI said.
Analysts believe that today’s decision could pave the way for a cut in retail lending rates that could see a reduction in the monthly payments on home, auto and other consumer loans.
Welcoming the RBI decision, Bhattacharya said: “We thus believe that this cut may be just the beginning of a rate easing cycle”, while Bank of Maharashtra Chairman S Munhot said many banks would now look at easing interest rates.
“We have already cut our base rate by 0.15 per cent last month in anticipation of rate reduction by RBI. Now we would look at some select sectors like MSMEs to reduce our spread,” he said.
While the retail inflation has slipped to 5 per cent in December, the Wholesale Price Index (WPI) inflation has remained near zero per cent in the same month.
Elaborating on the price situation, the RBI said, “Inflation outcomes have fallen significantly below the 8 per cent targeted by January 2015. On current policy settings, inflation is likely to be below 6 per cent by January 2016.”
Lower-than-expected inflation has been enabled by decline in prices of vegetables and fruits, cereals and the large fall in international commodity prices, particularly crude oil, it said, adding barring geo-political shocks, they are expected to remain low over the year.
The RBI, however, has decided to keep the cash reserve ratio (CRR), the portion of deposits which the banks are required to have in cash with the central bank, unchanged at 4.0 per cent.
Following reduction in the repo rate, the reverse repo rate has been adjusted to 6.75 per cent, and the marginal standing facility (MSF) rate and Bank Rate to 8.75 per cent.
The RBI in its fifth bi-monthly monetary policy statement in December had said that “if the current inflation momentum and changes in inflation expectations continue, and fiscal developments are encouraging, a change in the monetary policy stance is likely early next year, including outside the policy review cycle”.
In its public interactions, the RBI functionaries had committed to initiate the process of monetary easing as soon as data indicated that medium-term inflationary targets would be met, the statement said.
The December monetary policy had said that once the monetary policy stance shifts, subsequent actions would be consistent with this stance.
“Key to further easing is data that confirm continuing disinflationary pressures. Also critical would be sustained high quality fiscal consolidation as well as steps to overcome supply constraints and assure availability of key inputs such as power, land, minerals and infrastructure,â€ RBI said.
It said in the statement that there was a need to ensure that potential output rises above the projected pick-up in growth in coming quarters so as to contain inflation.
The RBI said that it would continue with daily variable rate repos and reverse repos to smoothen liquidity.
The central bank, it added, will â€œprovide liquidity under overnight repos at 0.25 per cent of bank-wise NDTL at the LAF repo rate and liquidity under 7-day and 14-day term repos of up to 0.75 per cent of NDTL of the banking system through auctions.”