1. RBI repo rate cut: interest rates do not matter if growth is high

RBI repo rate cut: interest rates do not matter if growth is high

Credit growth is better-linked with GDP growth; interest rates do not matter if growth is high

Updated: October 6, 2016 8:31 AM

There are some interesting features in the credit policy brought out by RBI on Tuesday. The first is that it continues to be a kind of bi-monthly review of the activities of RBI where it tells us what all has been done and what could be expected in the coming months. Second, the decision has been unanimous, which is significant as there are three academicians involved and everyone agreed that the rates should be lowered. Third, with the decision being taken by the MPC, it cannot be said that RBI was forced to lower rates by the ministry, which is often argued in some circles. Fourth, while the inflation goalpost of 4% has been maintained, RBI does not expect to move closer to this mark this year, and a 5% figure, by March 2017, is being spoken of. Fifth, the market will always find it hard to gauge the reaction of RBI while the inflation number moves along the corridor of 4-6% because, at times, the stance has remained unchanged while at other instances, like this one, the decision to lower the repo rate was taken. Lastly,

RBI has indicated that the targeted real-interest rate would be 125 bps as against 150 bps.
The repo rate impact is actually quite small as it needs just R2,500-3,000 crore to influence interest rates paid and charged by banks. Yet, it is the anchor for setting interest rates, and hence the issue of transmission has been alluded to by the Governor. The repo rate change enters the bank’s interest rate through the base rate calculation or the MCLR. The banks, however, would still be free to lend at any rate they wish depending on their risk perception, but can’t go below the base rate/MCLR.
How have banks acted so far? The accompanying graphic gives the movement in the repo rate, the average deposit rate of banks for a tenure of above one-year and the average base rate of banks (as presented by RBI).

The dynamics of interest rates changes is interesting. When RBI lowers rates and banks follow suit, lending rates would all tend to decline almost immediately, unless they are fixed rates for term loans. But deposit rates would get re-priced only on maturity as they are of a fixed-contract nature. Hence, deposit rates tend to move faster than the lending rate. Therefore, the present reduction in the repo rate may not lead immediately to a decline in the base rates of banks while deposit rates could come down.
An interesting calculation from the graphic is that the difference between the deposit and repo rate has never exceeded 75 bps and, hence, with the repo rate going down to 6.25%, the deposit rate would tend to gravitate towards the level of 7%, which will be at least 15 bps lower than it stands today. However, borrowers may feel better off as the difference between repo rate and the base rate has been less than 300 bps, though this differential was maintained at this level in FY16 and the first half of FY17. A correction of up to 25 bps may be expected with the repo rate, at 6.25%, and the base rate could move to 9.25%.

At the theoretical and ideological level, the issue which can be debated is whether a reduction in the base rate and thus all lending rates spur growth in credit. The graphic provides information on the growth in credit in various segments along with the so-called regimes of easy/tough rates as represented by the repo, which are mimicked by the base rates (though not in proportion).
Some interesting observations emerge here. Regimes of high interest rates did witness steady growth in credit, as seen in FY11, FY12 and FY14. In FY11, the repo rate had increased by 175 bps and yet there was growth of about 20% in credit. Further, by lowering rates, as was the case in the other three years, growth in credit had slowed down instead of increasing. In fact, growth in credit is better linked with GDP growth where interest rates do not matter if growth is high. In the last two years, growth has been stagnant, leading to lower growth in credit.

Also, low industrial growth has affected demand for credit and it can be seen that growth in credit to manufacturing trails that of overall credit. Services had witnessed higher increase in relative terms but this could be more due to the inclusion of NBFCs which have to borrow to do business. Retail credit growth has gone counter to that in the other sectors over the last 2 years and has been buoyant, indicating that not just demand has gone up, but banks have also shifted to this segment where delinquencies tend to be lower.

Hence, the cut in repo rate will lead to lower deposit rates—small savings rates have already been lowered. RBI believes that inflation will be around 5% and hence another rate-cut cannot be accommodated. Lending rates would tend to decrease this time as well, but it is a tough call on credit growth in response to this cut. It is a shoulder-shrug for manufacturing, but an affirmative nod for retail credit.

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As a central bank, RBI has made the right move to provide a boost to lending which can help industry. But until industry sees vibrant demand and the exhaustion of excess capacity, chances are that we may have to wait for a longer while for the investment cycle to resume. This is something we have to accept.

Madan Sabnavis

The author is chief economist, CARE Ratings. Views are personal

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