The RBI cut LAF repo and reverse repo rates by 50 basis points to 5% and 3.5% on Wednesday. A reading of the stimulus measure statement on Wednesday suggests that while ?India?s growth trajectory has been impacted? and that ?this impact has turned out to be deeper and wider than anticipated earlier?, the core concern for the RBI was the reported drop in bank credit. Amidst details in its statement, it pointed out that credit offtake during mid-December to mid-February FY09 was a mere Rs 8,000 crore compared to Rs 87,000 crore in the corresponding two months of the previous year.

Will the rate cut address the problem? Although the dynamics of bank credit are complex, the answer will depend on whether the slowdown in credit delivery is more a supply or demand issue. If there is a indeed a slowdown in bank credit, passing on a policy rate cut to bank lending rates is likely to have only a marginal impact in increasing credit demand.

It does seem that there is more of a drop in credit demand than a supply constraint at the moment. For one, over the past couple of months, banks have been parking an average of over Rs 45,000 crore at the RBI?s LAF reverse repo window. Call and other short term rates have also remained near the lower side of the LAF rate corridor. The RBI has facilitated, through a series of interventions, easy Rupee liquidity over the past few months. We expect that this situation will continue over the near future, even with the expected (transient) outflow of tax payments in mid-March.

On the other hand, there is ample anecdotal evidence of a slowdown in the capex plans of many investors, led by both a slowdown in domestic demand and of exports. The drop in non-oil imports is also an indicator of this slowdown. Much of the incremental demand for credit, therefore, is probably for working capital (WC), to manage inventories and receivables. There are multiple pressures on working capital demand. In the nature of the business, WC limits are tied to turnover (which has also come down due to commodity price drops), and consequently there is now bound to be a drop in WC limits fixed by banks. Even though there is a reported elongation of receivables (and payables) cycles, which increases the demand for WC, demand for WC lines have reportedly dropped. It is only when the recovery process starts and prices stabilise that WC demand will pick up.

From banks? perspective, increasing credit flows also depend on their assessment of credit quality of loan proposals. In addition, the impact of the global financial crisis has also impaired the ability of banks to augment capital, and this has again deepened the credit squeeze.

While these issues are relevant for the credit channels of policy, interest rate signals transmitted through the sovereign yield curve are also impeding a reduction in bank lending rates (see trends in the attached chart). Again, as has been pointed out in the RBI?s statement, yields on the 10 year government securities benchmark have hardened over the past month, based on the unexpectedly large increase in the government market borrowing programme. Although the links between market rates and bank lending rates are not as strong in India as in developed markets, there will inevitably be an opportunity cost-based risk-pricing of bank loans (for say a AA rated corporate) based on the corresponding sovereign yield. These are classic symptoms of the crowding out effects of higher public sector spending. As the accompanying chart shows, spreads of even AAA corporate paper (over sovereign yields) have remained quite high; lower grade corporate paper spreads remain much higher. The underlying credit risk levels that these spreads signal are also, completely rationally, being priced into bank lending. The chart also shows the movements of SBI?s 1-3 year deposit rate (as a rough proxy for banks? cost of funds), for comparison. Although the dynamics of this rate in relation to the corporate paper yields change over time, the spreads for both over sovereign yields have remained high after September 2008.

In short, while the rate cuts will certainly be an aid in banks decision to cut rates, there are other concerns that will need to be addressed. That the RBI is in full cognizance of these concerns is explicitly stated in its policy stimulus statement. But the RBI too is clearly constrained in pushing things beyond a limit; the exercise of prudence in bank lending during a sharp economic contraction is both practical and desirable.

Over the next few days, as greater clarity emerges on the modalities of the government?s borrowing programme and the mechanics of measures taken jointly with the RBI of facilitating the additional borrowings of the government, we expect yields to come off their current levels. This will also be an input, however weak, in banks? credit pricing decisions. Hopefully, a good rabi harvest will be the most effective stimulus that we might expect over the next quarter.

-The author is vice-president, business & economic research, Axis Bank. These are his personal views