The cut in the repo was expected, though the shift in the stance was an unexpected surprise; real interest rates are still too high
Given how growth has collapsed and inflation stayed benign, RBI had both reason and the room to be accommodative. While a 25-basis-points cut in the repo rate, to 5.75%, had been pencilled in, the shift in stance to ‘accommodative’ was a surprise and thrilled the bond markets. Not only are rate hikes off the table for now, liquidity too will likely be in surplus from now on. RBI’s recent liquidity infusing measures—open market operations—have already seen wholesale rates in the money markets trending down by 25-50 basis points.
However, bankers are not sure the abundant liquidity alone will translate into very meaningful cuts in deposit rates or, therefore, loan rates. To be sure, both deposit rates and loan rates could be trimmed by 10-15 basis points, but, taken together, with the 20 basis points weighted average fall since February, this would add up to a fall of only 30-35 basis points in loan rates, as against a much steeper 75 basis points cut in the repo. Governor Shaktikanta Das’s belief that transmission will be faster this time around seems optimistic. The fact is banks have been apprehensive of lowering interest rates on deposits because the returns from small savings are more attractive. Also, there is evidence that household savings are slowing since incomes aren’t growing fast enough. Governor Das must impress upon the government the need to lower rates on small savings so as to make deposits more attractive, else, banks won’t have the room to cut deposit rates. Repo rates may be at their lowest in nine years but real rates remain high—around 5.4%—so even if industry believes demand is looking up, it might be unwilling to invest at these levels.
Inflation is unlikely to go up too much—food inflation is rising but core inflation is softening—and, therefore, most economists believe the central bank would cut rates again either in August or October. The MPC now expects inflation in H1FY20 at 3.0-3.1%, slightly higher than the earlier 2.9-3.0%, and H2FY20 inflation at 3.4-3.7% , a shade lower than the earlier forecast of 3.5-3.8%, with risks broadly balanced. However, these estimates suggest the government will be fiscally prudent and that the deficit will be reined in at levels of 3.3-3.4%. Governor Das was appreciative of the Centre having stayed on the fiscal glide path and did not seem concerned about the large extra budgetary resources which threaten to crowd out private sector borrowings. Indeed, not so long ago, the bond markets were positively nervous about the large quantum of off-balance-sheet borrowings the government had resorted to in FY19. Das chose to speak about public sector undertakings which repay their market loans from internal accruals, and did not dwell on the rollovers of subsidy payments. However, given how the tax collections have fallen short of the targets, there is every chance the government will be compelled to tap non-budgetary sources this year too, since strategic sales may not yield too much. So, the risk of the private sector getting crowded out remains unless foreign portfolio investors retain their appetite for Indian bonds, which is a distinct possibility. Right now, though, RBI’s growth forecast of 7% for FY20 is a bit of a stretch.