Fed move revives hopes of RBI rate cut

Srikesh P Menon & Ujjal K Basu Roy

Mumbai, Oct 3: Hopes of a Bank Rate cut by the Reserve Bank of India (RBI) were again revived after the US Federal Reserves cut its interest rate by 50 basis points (bps) to 2.50 per cent, late on Tuesday.

This is the second such cut since the September 11 terrorist attacks, and it puts overnight US interest rates at the lowest level in 39 years since May 1962. With this, there has been a reduction of 400 bps in the US Fed rate spread across nine cuts since January this year. The RBI bank rate, which is used by most commercial banks to price their loans, is currently at seven per cent. The Fed is ready to act again if needed, given the economic uncertainty caused by the Sept 11 attacks. The Fed is hoping that the latest round of rate cuts will spur consumption expenditure and investment.

But it is expected that incremental investment will stay stagnant for sometime since over-investment is one of the causes of the recession. Moreover, the recession this time has been a structural one. Until and unless, the realignments take place, investment is expected to stay static.

Said JP Morgan’s head of research, Siddharth Mathur: “The interest rate differential between the US and India gives an enabling factor to the RBI to effect a bank rate cut. The market is expecting a bank rate cut within a month. The economy needs a stimulus to grow at its potential. The extent of fiscal stimulus is limited by the high fiscal deficit. The efficacy of a bank rate cut may be debatable but there is no reason whatsoever for a bank rate cut not to take place. We are expecting a reduction of 50 bps.”

Said Centurion Bank’s executive director, J Moses Harding: “An imminent bank rate cut by the RBI has been looming over the market for quite sometme now, but the central bank does not seem to be getting the right time to effect it. At the moment, liquidity in the banking system is ample and no one is complaining about rates so there is no immediate need for a rate cut. Also the RBI can use the rate cut like a ‘trump card’ to counter any negative market sentiment as we have seen in recent days hopes of a bank rate cut always improves the market sentiment.”

Added Mr Harding: “The rate cut may come in the credit policy on Oct 22 or if there is no negative sentiment the RBI can also push the rate cut plans to December, but that may be a bit too optimistic.”

Said a private banker: “Where is the need for a bank rate cut in India? It is only bond dealers and the government of India (GoI) which wants a rate cut here. The profligate GoI which otherwise does not do anything, wants cheaper funds for its huge borrowings.
It is only certian sections of industry who have not yet adjusted to lower import duties and the WTO who want a rate cut. A rate cut will encourage a shift from productive assets to unproductive assets like gold. Banks do not want to lend at the moment due to other reasons like lack of bankable credit and viablle projects. A rate cut is not the panacea for all ills.”

The rate differentiial argument is not valid since there are no free debt flows and whatever inflows come in, they are in the nature of portfolio.