Monday, March 30, 2009

>Macroeconomic Research (FIRST GLOBAL)

Food for Thought: Will the rate cuts help?

Benefits of earlier rate cuts yet to percolate down the system & help arrest economic slowdown…

Is the headroom from low inflation for further rate cuts merely theoretical…

The Story…

The Reserve Bank of India (RBI) has been on a rate-cutting spree, along with most other Central banks of the world. Lately, it has lowered its policy rates, the Repo rate (the rate at which RBI lends short-term funds to banks) and the Reverse Repo rate (the rate at which overnight funds are parked with it), under the Liquidity Adjustment Facility (LAF), each from 5.5% and 4% to their new levels of 5% and 3.5% respectively. Before the rate-cutting cycle started, the Repo and Reverse Repo rates were at 9% and 6% respectively. The RBI has maintained its status quo on the Cash Reserve Ratio (CRR), the amount of cash balances parked by banks with it as a percentage of the net demand and time liabilities, at 5% since the last cut by 50 bps.

The easing of RBI’s monetary policy began from October 2008 onwards and so far, it has slashed the Repo rate by 400 bps, the reverse Repo by 250 bps, and the CRR by 400 bps. The RBI’s key aim behind the cuts is to signal banks to lower their lending and deposit rates and shed their risk aversive approach by passing on the benefits of the easing of its monetary policy to the productive sectors in order to stimulate demand and increase confidence in the economy. The lowering of the reverse Repo rate lowers the incentive for banks to park their surplus funds with the RBI on its LAF window, as a result of which, banks are expected to cut their lending rates. Though banks have reluctantly reduced their PLR rates, with the benefits of these cuts have not really percolated down the system and arrested the economic slowdown, as evident from the continuous negative data coming in. In April’08-January’09, the IIP growth stood at 3%, which is almost one-third the growth of 8.7% recorded during the same period in same period in the previous year, due to the slowdown across all the key sectors. Exports have recorded a decline for four consecutive months from October 2008 to January 2009. Theoretically at least, the low wholesale price inflation provides the RBI with sufficient headroom to extend rate cuts in the absence of any fiscal measures during the code of conduct period.

■ The Inflation provided monetary policy cushion may be illusory : The WPI inflation is expected to touch 0% to a negative 1.3% by the end of March 2009 and shall remain negative till October- November 2009, mainly due to the double-digit base effect. While part of the reason for the discrepancy between the WPI and CPI is the lag effect, the differences in the basket weights are also to blame. Food inflation, for instance, remains fairly high even in the WPI basket. This means that an easy monetary policy may not be a costless proposition.

■ Bond yield movements: The RBI’s borrowings have already surpassed the targeted levels by 80% to Rs.2.61 trillion for FY09 vis-à-vis Rs 1.45 trillion in FY08. As a result, the long-term (20-year and 30-year) and medium-term (5-year and 10-year) G-secs have lost their attractiveness, based on the expectation of a deluge of G-secs entering the market in the coming months. Rate cuts and falling inflation alone cannot ensure a softening in the soaring medium and longterm G-sec yields and it is only consolation in the form of the RBI’s decision to purchase Gsecs under OMO that could provide the much-needed relief.

■ Key sectors that may benefit:

  • Auto: The policy rate cuts will signal banks to provide cheaper finance to these segments in order to help stimulate consumption and help the ailing Auto sector. Hence, banks could further lower their lending rates for these segments.
  • Banking: Instead of sitting on idle cash, banks can choose to lower their lending rates in the coming months and also reduce their deposit rates, primarily to improve margins. The trade-off here will depend on how the government bond rates move.
  • Real Estate: Since the interest rates have already been reduced significantly, the possibility of a further cut in lending rates appears unlikely, unless banks lower their deposit rates from the current 8.5-9% level.

■ Conclusion: We maintain our view that another cut in the policy rates by the RBI is imminent, though the exact timing of these cuts cannot be predicted, as inflationary pressures will vanish in the next two months and provide more room for such rate cuts.