The Right Rate

The Right Rate
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The central bank has done well to guard macroeconomic stability

ON OCTOBER 4TH, the Reserve Bank of India held constant its repo rate—the key policy rate of interest that sends a signal to the banking system—at 6 per cent. In its last rate decision, in August, the central bank had reduced this rate by 25 basis points—or a quarter of a percentage point. In taking the decision, the RBI highlighted the renewed risk of rising inflation. It raised its inflation forecast for the second half of the year to 4.2-4.6 per cent, up from 4-4.5 per cent.

The central bank listed several risks that lie behind its elevated projection of prices: farm loan waivers; the implementation of Pay Commission salary hikes in states; and a slew of price revisions following the Goods and Services Tax (GST). The decision was contrary to what some analysts had expected, but there has always been a view that the most the RBI could cut its repo rate in this money-loosening cycle was no more than 50-75 basis points. To that extent, it has been consistent.

The case for a rate cut to boost economic growth rests on the claim that lower rates—transmitted from the policy rate to what various banks charge on loans— would lower the cost of borrowing for companies and lead to a pick-up in commercial activity. As things stand, such optimism is not warranted. India is in the midst of a double-balance sheet problem: banks have a very high number of loans that have gone bad or are on the verge of default. This number is expected to rise in the next six months. Many companies are also reeling under earlier loans taken for projects that have either stalled or turned sclerotic. Power and infrastructure are badly hit sectors. Under such conditions, a lowering of the policy rate may not be sufficient to kickstart credit. The transmission of rates from the central bank to commercial banks takes anywhere upto three to six months, depending on the quantum of the rate cut. The RBI is known not to cut rates precipitously in any case.

An investment uptick, crucial for a wider economic recovery, is likely to take time. In the meantime, such structural reforms as GST implementation should clear the path in the months and years ahead for a predictable policy landscape. This, more than cheaper loans, holds the key to a sustainable revival.