Going halfway

Policy rate cut by the RBI may not translate into lower bank lending rates

In an attempt to give impetus to investment and growth in the Indian economy, the RBI has cut policy interest rates by 25 basis points. This is a welcome move as investment shows no signs of picking up so far. The RBI appears to have responded to the steps taken by Finance Minister P. Chidambaram to cut the fiscal deficit as well as to restore optimism about the economy through a series of steps such as clearances for stalled investment projects. Keeping the fiscal deficit under control and reducing subsidies are factors that will determine the future direction of monetary policy and the scope for further easing.

The RBI has been cautious in its approach because inflation remains far above the target levels. Looking ahead, however, international commodity prices are expected to show a decline, both due to global developments in the oil sector and the decline in demand because of the slowdown of growth in China. Further, food prices remain high and the RBI is still unclear in its stance on how far monetary policy affects food prices. Supply shortages in food remain, especially in fruit, vegetables and fertilisers, and it is unlikely that they will go away soon. It is thus likely that the RBI expects that non-food prices will decline due to lower global and domestic demand factors, resulting in lower inflation.

The transmission of the lower policy rate to lending rates of banks may be limited. The liquidity situation in the banking sector is tight and the call rates have been hugging the top end of the corridor. The RBI has chosen not to cut the CRR as it is already low at 4 per cent. In this sense, the monetary policy goes halfway while it cuts policy rates and signals that it is concerned about growth, it does not take the next logical step of providing the banking sector with the means to cut liquidity. One of the reasons for this may be the fragility in the banking sector. As the growth of troubled assets in the banking sector rises, with some of the best customers of banks caught in uncomfortable predicaments, the RBI may be reluctant to make loans easily available. The transmission to lower bank lending rates, the pick-up in credit growth to industry and an improvement in investment may still be some way off.

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