The Anatomy Of Repo rate and Rate cut

The Anatomy Of Repo rate and Rate cut

The Anatomy Of Repo rate

News: The Reserve Bank of India (RBI) lowered its benchmark interest rates for a fourth straight meeting today with a slightly bigger than an expected cut of 35 bps.

What is Repo Rate, how does it impact the general public?

Once in every two months, the Reserve Bank of India (RBI) makes a Monetary Policy announcement in which the central bank announces the changes in Repo Rate and Reverse Repo Rate. These rates are decided by the six-member monetary policy committee (MPC), which is headed by RBI Governor.

What exactly do these rates indicate and why are these changed by the MPC?

Repo Rate is the rate of interest at which the RBI lends money to banks. Simply put, the government would want to lower the Repo Rate when it wants to boost economic activity. It is a way to infuse money or cash (liquidity) in the economy when there are signs of slow down. If Repo Rate comes down, then it would cost banks less to borrow from the RBI. This, in turn, allows the banks to lend in the market at a lower price without having to compromise with its own profit margin.

Once the lending rate of banks come down, the businesses would hesitate less to borrow and invest. After all, a business, of any kind, is about earning more money than what has been spent. A large part of what has been spent or investment would be in the form of borrowings from the bank.

So, what a business or company earns should not only cover its costs on wages to the employees, raw material, process involved in getting a product or service ready for market, but also the interest it pays on the money borrowed from banks. Essentially, when the lending rates come down, more businesses would want to borrow and invest in the expansion of the business which in turn boosts the economic activity.

This is the concept behind lending rates, repo rates and their relation with the economic activity on the ground. In reality, many other factors play a role in determining the level of economic activity. Like, if a company begins to scale up the operations just because the banks are lending at lesser rates without considering if there is even a demand in the market for its offerings, then it would be doomed. Repo Rate is one of the key factors that influence economic activity. More the economic activity, more would the jobs be created, the average incomes would go up which may increase spending. Once spending by people goes up, many sectors benefit. All this is a big economic cycle with a chain of events affecting others, but the exact magnitude of the effect of a particular move could be hard to find.

What does it mean?

The 35 bps rate cut is a signal that the Reserve Bank of India’s MPC is quite concerned with the growth outlook. Indeed, the RBI lowered its economic growth forecast to 6.9% from 7% for the current fiscal year and said it sees inflation remaining inside its target range over a 12-month horizon.

MPC viewed a standard 25 bps cut as being inadequate in view of the evolving global and domestic macro-economic conditions, while a 50 bps cut was seen as potentially “excessive”, given past RBI actions. Still, see scope for rate cuts as inflation is likely to remain muted. The recent rate cuts in tandem with anticipated government moves should lift sluggish economic growth.

The real challenge: GETTING BANKS TO CUT RATES

RBI has cut the repo rate by 110 bps this year. But the real challenge remains to get India’s banks to pass rate cuts to borrowers. The real issues are improving monetary policy transmission and reviving the non-banking finance companies sector; the policy does not provide any new measures or even perspectives on these areas.

State Bank of India (SBI.NS), the country’s biggest lender by assets, cut its benchmark lending rate by 15 bps across all tenors shortly after the policy announcement. Since the start of the year, SBI has cut rates by just 30 bps in response to RBI’s 110 bps cuts. It is equally important that the government front-loads its capital expenditure program for the current year and continues to push ahead with the reforms program.

Who benefits?

If banks transmit this reduction in the prime lending rate to consumers, budget housing demand may improve. Likewise, housing demand in tier-2 and tier-3 cities, where property prices are relatively less prohibitive, may see an uptick, he felt. But tier-1 cities, where the high prices are the deterrent, not interest rates, the RBI move may not be of much help to boost demand. RBI’s 35 bps rate cut is only marginal, especially so for the real estate sector. The NBFC liquidity crisis has severely choked credit availability for the industry, especially developers, as they struggle to raise even construction finance.

With interest rate reductions, improved market sentiments due to the tax deduction schemes, modified tenancy laws, focus on the implementation of PMAY, and the investment in infrastructure announced in the Union Budget 2019-20 may combine to boost sales in the residential segment.

Moreover, credit re-structuring measures such as the introduction of repo-linked loans by some banks could sway purchase decisions of home buyers while enhancing transparency. However, the growth trajectory of the real estate sector ultimately depends on the successive transmission of rate cuts to the end consumers.

Why continuous Repo rate reductions?

The Indian economy is going through a cyclical slowdown which also has shades of structural elements in it. At a structural level, several years of investment decline have been due to the problem of three ‘D’s; Demand, Debt (of corporates) and Default (non-performing assets of banks). While debt and default are on the mend with gradual deleveraging and partial success of the insolvency process, lack of demand is a stubborn bottleneck still. The demand problem, in turn, could be connected to two important structural issues – job/wage growth and a rural economy suffering from a lack of nominal growth.

To accentuate the domestic demand problem, external demand has also plummeted in the last few months. India’s export growth is now averaging only 1 percent in the last eight months compared to 12 percent in the eight months before that. The point-to-point decline looks even starker – from 19 percent growth in August 2018 to de-growth of 10 percent in June 2019.

This is partly due to the rather sharp decline in global growth and partly because of a secular decline in elasticity of global trade to global growth. As a result, India is unable to compensate for the slowing domestic demand through higher external demand despite India’s share in global trade increasing marginally to 1.8 percent from 1.7 percent a year ago.

How to tell if it’s a slowdown and Why Was The Slowdown So Sudden?

Gross domestic product declined from 8.0 percent in June 2018 to only 5.8 percent in March 2019 which is unusual because cyclical slowdowns often take longer to manifest.

In my view, the domestic consumption demand was supported in the last five years through a substantial lowering of savings (almost 8 percentage points of GDP in last eight years) and increased household borrowing (in particular, the share of these borrowings from NBFCs were consistently increasing)..It was difficult to sustain this pace of consumption growth as on one hand, reducing savings rate any further became difficult and on the other, the lack of credit support from struggling NBFCs made matters worse despite banks retail lending holding up for the time being. The suddenness in the NBFC credit freeze is quite apparent when we notice that the share of NBFCs in overall non-bank credit to the commercial sector plunged to 1.5 percent in FY19 from 22 percent last year. It could have impacted not only the final consumer demand but also business demand from smaller players in sectors like real estate, construction, autos, etc.

Why low rural demand?

A large part of the rural demand problem could be traced back to lower realisation for the farmers despite crop output at historic highs. The large MSP increase of 2018 also did not change the price dynamics much as global food prices remain depressed. The challenges in the farm sector were complicated by a lack of mobility towards non-farming jobs.

More recently, the demand shortfall was also because of government spending coming to a halt in the April-June quarter due to the elections. The expenditure growth for the central government in this quarter has been only 2 percent. However, the silver lining is that this leaves some space to boost expenditure in the second half since the full-year expenditure is budgeted to grow by 21 percent. This could especially be the case with public CAPEX which has a much higher fiscal multiplier.

What could arrest this slowdown before it gets worse? 

Fiscal space appears to be limited as the government wants to stick to the fiscal glide path suggested by the FRBM rule and avoided announcing any explicit stimulus in the recent budget. Although the government is liberally using off-balance-sheet ways of spending and supporting public CAPEX(Capital Expenditure), its impact is not visible as yet. Another option for the government is to directly address concerns in the sectors which have been affected more by the slowdown. This strategy could have a relatively lesser fiscal cost.

Rate cut and slowdown:

The growth outlook explained earlier might nudge the MPC to lower its GDP growth forecast for FY20 from 7 percent. Even if there is a marginal increase in RBI’s CPI forecast, we do not think that it will deter the MPC from reducing the policy rate by 25 basis points taking the cumulative reduction in 2019 to 100 basis points. Supporting growth is a more immediate concern and there are no signs of inflation substantially exceeding the 4 percent target. Core inflation, expectedly, is moderating fast on the back of slowing growth and rise in food inflation has been less than feared despite an uneven monsoon. Global central banks tilting towards an easing bias would also be indirect support.