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Case for a Rate Cut

By Anand Mishra
In Financial Inclusion
January 13, 2015
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policy-ratesThe downward movement of price rise continues in India. The Wholesale Price Index (WPI) inflation which  captures inflation at wholesale level, has continued to come down in November and dropped to an unprecedented zero level for  the month. The figure during the previous month stood at 1.8 per cent, the data released by commerce and industry ministry showed. The WPI inflation stood at a high 7.5 per cent during the corresponding month of the previous year. The WPI’s declining trend was accompanied by a significant decline in the retail inflation, measured by CPI, which dropped to a multiyear low of 4.4 per cent during the month.

The decline has emboldened the industry lobby which has been demanding an interest rate cut from the RBI. What they have been saying is that since inflation has gone down to very low level, interest rates, which had been kept at a high level just to fight off inflation, should come down. They also say that with inflation hitting a very low level, the real interest rate has become inordinately high. Nominal interest rate is essentially a combination of both inflation and real interest rate. High interest rate has been hitting India Inc. hard as the financing cost has been impacting its balance sheet adversely. A leading exporter from Pune commented that the higher cost of financing has made his exports uncompetitive. The story is same for all manufacturers who are reeling under  sluggish demand and high cost. This, according to industrialists, is hurting employment generation and economic growth.

A rate cut in offing?
Reserve Bank of India (RBI), under the stewardship of Raghuram Rajan, has fought the interest rate cut lobby hard for an entire year now. The basic argument of RBI has been that monetary policy can and should be used to tame inflation, even if it hurts industry momentarily. In its fifth bi monthly policy statement, it had mentioned that the recent decline in inflation has been because of a few factors such as softening crude prices and easing in vegetable prices. In nonfood category, lower crude had resulted in lower than expected transport and communication prices, driving down inflation.

RBI had also noted in its statement that the November inflation which has just come out, could ease further, but the favourable base effect that is driving inflation down, will dissipate and inflation for December could show an upward trend. This was the reason why it did not cut the interest rate then. However, if the inflation for the month of December could also come out to be much below RBI’s own target of 8 per cent, Raghuram Rajan would find it very hard to resist a cut in interest rates. Indian Finance Minister Arun Jaitley has been reported to support a cut in interest rates and had argued in October 2014 that currently prevailing interest rates were a disincentive and that the time may have have come to moderate the interest rates in wake of stabilizing inflation. Inflation sustaining at lower levels could give RBI some elbow room to play with interest rates which would be most welcome by the industry. That would also allow real interest rates to come down which are at a very high level currently.

Bringing respite to economy
Last year, record number of Indian enterprises went for debt restructuring. A major reason for such a request was the massive cost of servicing debt. A significant number of businesses were reported to have closed shop simply because they could not cope with the finance costs. All of these enterprises would be major beneficiaries of a decline in interest rates. Secondly, because financing cost would come down, many projects which are currently unviable, would become viable, encouraging enterprises to invest more and generate jobs.

For common folks, an interest rate decline could bring some tangible benefits. First of all, the EMIs or the monthly instalments on existing loans would come down if they are flexible in nature. Sometimes, loan providers allow customers to reset interest rates once or twice during tenure of loan and that facility could be availed with a decline in interest rates. Secondly, it would be easier to finance new loans at lower rate, increasing sales of  consumer durables and automobile sectors.

While debate has been raging on about whether it is the right time to decrease benchmark rates and what would be the stance of RBI in its forthcoming policy review in Feb 2015, financial markets have started to factor in the decline in interest rates. The yield on benchmark 10 year government paper has shown a declining trend over last few months and has reached sub 8 per cent levels in last month or so. This has resulted in increase in prices of debt papers, which run opposite to the yields. Resultantly, most debt based funds have generated good returns. A look at the gild based mutual funds shows that on a yearly basis, many funds have generated over 19 per cent returns which is a great performance for funds which invest overwhelmingly in government papers. A financial advisor based in Delhi commented that over last six months, attractiveness of debt based funds has increased and it was now much easier to sell such mutual funds.

The ball is now in RBI’s court to take a call on whether to decrease interest rates and by how much. Government  has been indicating that it is in favour of lower interest rates. Industry is vociferous in demanding a rate cut and some brokerage houses are also of the view that with inflation declining to low level, it makes sense to cut rates. But RBI which has been looking at all elements of prices, could be looking at the consumer price inflation for  industrial workers which has inched up even as other indicators of inflation have come down. Either way, next couple of months would be worth watching for economists and investors alike.