What the RBI’s rate cuts can and cannot achieve

Reserve Bank of India (RBI)

With the RBI’s recent cut in the repo rate (it is the rate at which the central bank of India lends to other commercial banks), the number has hit a nine-month low of 5.75 percent. Given the sagging economy reflected in the low GDP growth rate, this was an expected, logical step.

However, the commercial banks, it seems, are in no mood to pass on the rate cut to their customers, who borrow from them in the same manner they borrow from the RBI. A humungous pile of bad debts, which have little chance of being recovered and poor household savings have put a strain on their resources to lend. This has made them hesitant to cut down their lending rates as well.

Since January 2014, the RBI has reduced the repo rate by 2.25 percent. But both public and private commercial banks have passed just a fraction of the rate cuts to consumers. The question playing on everyone minds now is if the RBI has the power to coax the banks do to so.

And if it were to happen, how would it resurrect the economy?

In two ways basically – by filliping investment and consumption.

By investment we mean borrowing by businesses to expand or set up new units. With lower rates of borrowing, private investment would receive major tailwinds, leading to export and job growth. However, this was clearly not the case in India. Comparatively higher interest rates have dealt quite a blow to greenfield projects and plant expansions in the past five years. As per CMIE (Centre for Monitoring of Indian Economy), the nation’s private investment is at a 14-year-low. And that is serious cause for concern.

On the consumption front, the same logic holds. With lower rates, people are encouraged to take out loans to buy houses, consumer durables, automobiles and even FMGCs (fast moving consumer goods). This would increase trade and commerce and eventually drive manufacturing and job growth. In fact, if the RBIs rate cut is matched by the commercial banks, it would provide a major shot in the arm of auto and housing sectors which have seen massive slowdown in the past few years. And both the sectors are key to economic growth.

Are the rate cuts enough to revive the economy?

No, this is not the magic wand. More funds need to be freed up for lending to businesses and households. One way of achieving this is by drastically reducing the amount banks are forced to lend to sectors marked as priority by the government. At present, about 60 percent of the available credit is funneled into the priority sectors leaving little for businesses that can bring about economic growth.

Not just that, economic experts and market pundits point out “structural reform and liberalization” of the financial sector is also important. At present, the bad loan ridden public sector banks, which are in a little position to lend, are the main funding source for the industry. Capital markets comprising of corporate and municipal bonds, private equity, venture capital, non-banking financial companies, peer-to-peer funding is yet to be mobilized properly here. This is to be blamed for an outsized banking sector and crony capitalism too. With optimal utilization of such alternate capital sources, competitive industries will get a major lifeline and thrive once again.