With large amounts of govt—and PSU—paper, the issue is whether yields will rise, so not clear interest rates will fall
Given how inflation has been benign, driven down by soft food inflation, and is well within the targetted 4% plus-minus 2% range, it is not surprising RBI opted to trim the key repo rate by 25 bps to 6.25%. Indeed, crude oil prices have fallen sharply from recent peaks and subdued global growth is expected to leave prices of other commodities soft and interest rates, too. These factors, together with expectations food prices will stay quiet—at least until the cropping patterns change—have led RBI to substantially lower its inflation forecasts. So, inflation in H1FY20 is now expected to be 3.2-3.8%, 60 bps lower than the December 2018 projections, while inflation for Q3FY20 has been pegged at 3.9%.
The bond markets were understandably cheered by the cut in the repo and the change in RBI’s stance to neutral from one of calibrated tightening. However, they are likely to be very circumspect given the huge supply of paper that is on its way, with the Centre and the states scheduled to borrow a gross Rs 13 lakh crore in 2019-20. Consequently, yields at the longer end are unlikely to fall especially since the market isn’t quite sure about the quantum of OMOs that RBI will conduct. Again, while the central bank does not seem to be perturbed by the massive extra-budgetary borrowings by the Centre, the bond market will take cognisance of the fact that, at some time point, this, together with the increased expenditure on farmers, will show up in higher aggregate demand and in prices. Governor Shaktikanta Das refrained from commenting on the extra-budgetary borrowings but said all other data points will be closely watched to determine future rate cuts.
While the MPC has treated the sharp uptick in health and educaton costs as a one–off this time, the stance would definitely need a re-look if these prices stay persistently high. In the meantime though, subdued prices, and the slight fall in the output gap, more than justify Thursday’s cut in the repo. Unfortunately, though, there is unlikely to be any immediate transmission of this to lower loan rates for borrowers. That is because deposits—the biggest source of funds for banks—have been growing at a much slower pace than credit has. Thus, lenders will need to keep interest rates on deposits high, if not raise them further, and if they want to protect their margins it would be hard for them to drop loan rates. If the economy starts gaining more momentum though, there will be demand for credit even at higher rates of interest. In the meanwhile, the smaller presence of NBFCs in the financial system will keep loan rates firm. While foreign portfolio investors (FPI) have been sellers in the bond market, they could be more enthused now that they can invest more than 20% of their portfolios in a single company. However, the move to lower the risk-weight for NBFC loans and benchmark it to credit ratings is a bad idea given rating agencies have been slow to spot weaknesses in the books of NBFCs. Again, while allowing banks to give farmers collateral-free loans of up to `1.6 lakh might seem valid given the Rs 1 lakh ceiling is a decade-old, the fact is such measures tend to vitiate the credit culture.