Why the RBI should cut rates again

In May, the Reserve Bank of India (RBI) had hesitatingly cut the repo rate by 0.25 percent, which made no impression on the stock market or commercial banks. That was because both expected the cut to be more substantial. But the RBI had not obliged.

Perhaps the monsoon, which arrived on the dot and is progressing satisfactorily, may make some difference to the RBI’s expectations of food inflation – which had been its principal reason for hesitancy. While it’s too early to predict monsoon behaviour for the rest of the season and the likely improvement in agricultural production, it does appear the improvement should be significant and inflation dampened perceptibly. Reduction in inflation, however, is not the only reason why the interest rate should have been cut.

The other reason is to stimulate investment and enhance growth that is necessary to generate employment. Higher interest payments eat into earnings and reduce net profitability. In the quarter ending March 2013, interest payments were 29 percent of profits before tax. A 2 percent reduction in interest rate would increase net profits by 6 percent.

Interest rate matters. Most countries within sight of recession have taken every possible measure to reduce the interest rate. In countries such as Japan, even the nominal interest rate has been close to zero. In the United States, the real interest rate (nominal interest rate minus the rate of inflation) has been negative. We are among the few with an over 7 percent rate.

A lower interest rate is also necessary to make financing of investment possible. For companies need different types of funds in certain proportions. Principally, equity has to fund more than a third of capital, the rest coming from debt. When interest rate is excessive, people’s savings are diverted to debt and companies find it difficult to float equity. That is true even of the FIIs.

The RBI will make a review of credit policy on June 17. It’s an excellent opportunity to make up for the delay in rate reduction. But it is not enough to take baby steps and cut rates by 0.25 percent at a time. It took a year for the RBI to cut the repo rate by 0.75 percent.

To create an impact, the cut has to be impressive. A 0.5 percent cut at a time can make a lot of difference. In a year, a reduction by 200 bps can change the investment scenario dramatically. That is exactly what the RBI did in 2009. The rate was cut from the peak of 9 percent to 4.5 percent and the growth rate surged.

That can happen once again in 2013 with improvement in governance and clearance of projects for early implementation. But projects must be profitable and equity-attractive. The RBI has a chance to do that.


Author : D H Pai  Panandiker