RBI lowers lending rate but don't expect more cuts soon

On Tuesday, January 29, the Reserve Bank of India (RBI) surprised the money market by the extent to which it loosened monetary policy. The central bank lowered its interest rate and injected liquidity into the banking system. However, it chose to temper expectations for the rest of the year by pointing out that India's fragile macroeconomic indicators precluded the possibility of aggressive loosening in the near future.

Monday's policy reduced the repo rate - the rate at which the RBI lends to banks - by 25 basis points to 7.75 per cent, and lowered the cash reserve ratio (CRR) by 25 basis points to four per cent. CRR is the extent of banks' deposits impounded by the RBI as a prudential measure. Lowering the CRR releases more money into the banking system.

The subtext of RBI governor D. Subbarao's policy speech suggested that the central bank believes monetary policy has almost run its course in combating inflation and spurring economic growth. It is for the government to tighten fiscal policy and intervene decisively in policy matters to choke inflation and boost growth.

"In the absence of an effective supply response, inflationary pressure may return and persist with adverse implications for macroeconomic stability," said Subbarao, suggesting that the government needs to intervene to clear infrastructural bottlenecks.

Following the policy announcement, Rohini Malkani, economist at Citigroup India, forecast that the RBI would cut the repo rate by another 50 basis points (100 basis points make up one percentage point) in 2013.

In April 2012, the RBI cut the repo rate by 50 basis points in a single stroke.

Monday's loosening of monetary policy may not quickly translate into lower lending rates at the level of banks. The extent of bad loans on the books of banks and the slowdown in the growth of bank deposits in relation to bank credit have partially offset the impact of RBI's policy loosening in the recent past.

Taking a look at the extent to which monetary easing last year impacted banks in the third quarter (October-December) of 2012/13, Subbarao concluded: "The weighted average lending rate as well as the modal base rate remained broadly unchanged over the quarter."

Subbarao's speech identified India's balance of payments challenges as the primary risk facing the economy. This, in turn, prevents the RBI from adopting a policy of aggressive interest rate cuts, he added.

In the second quarter (July-September) of 2012/13, India's current account deficit, the excess of imports over exports, was 5.4 per cent of gross domestic product, a record level. Subbarao said that data for the next quarter would be worse, implying the Indian economy is very sensitive now to the flow of foreign investment.

India's vulnerability on its balance of payments front partly influenced Finance Minister P. Chidambaram's decision to address investors through road-shows in Hong Kong and Singapore in the fourth week of January.

Subbarao's policy lowered both growth and inflation forecasts for 2012/13. The economy will grow 5.5 per cent in 2012/13, he said, lowering the projection marginally from the RBI's October forecast of 5.8 per cent.

Inflation would be at 6.8 per cent at the end of 2012/13 compared to the earlier forecast of 7.5 per cent, said the RBI governor. In the next financial year, inflation is likely to remain around this level, limiting the room monetary policy has to spur economic growth, said Subbarao.