RBI cuts rates...but markets remain skeptical

The Reserve Bank of India (RBI) decided to lower short-term borrowing costs by 50 basis points as part of its continuous efforts to revive lending and boost consumption as well as investments in a sluggish economy. As a result, the central bank cut the repo rate by 50 bps to 5% with immediate effect. Repo rate is the rate at which the RBI lends money to banks. The RBI also trimmed the reverse repo rate by 50 bps to 3.5% with immediate effect. The move didn't have much of an impact on the markets. The stock market actually declined amid mounting concerns over the worsening global situation. The bond market on the other hand continued to be under pressure due to high Government borrowings and the consequent surge in the fiscal deficit.

"It is expected that the reduction in the policy interest rates will further encourage banks to provide credit for productive purposes at viable interest rates," the RBI said in a statement. The central bank added that it would continue to maintain ample liquidity in the banking system. "Since the release of the Q3 review on January 27, the global financial and economic conditions have further deteriorated, the RBI said, adding that the uncertainty on the recovery has increased.

Since mid-September 2008, the RBI has reduced the repo rate by 400 bps from 9% to 5%, while the reverse repo rate has been slashed from 6% to 3.5%. The cash reserve ratio (CRR) has been cut from 9% to 5% of net demand and time liabilities (NDTL) while the statutory liquidity ratio (SLR) has been lowered from 25% to 24% of NDTL. The cumulative amount of actual or potential primary liquidity made available to the financial system through various measures initiated by the RBI amounts to over Rs3.88bn.

Concerns over rising credit risk together with the slowing of economic activity appear to have moderated credit growth, the RBI said. The central bank continues to urge banks to monitor their loan portfolio and take early action, to prevent asset impairment down the road and safeguard the gains of the last several years in improving asset quality, it added. At the same time, banks should price risk appropriately and ensure that creditworthy enterprises continue to get funding, the RBI said.

With elections to be held between April 16 and May 13th and a new government likely only by June, the onus of reversing the current economic deceleration will largely fall on the RBI. Given that inflation is sliding steadily there is a chance that the central bank may go for further monetary easing in the coming months. While the RBI may not touch the reverse repo rate, it is likely to move towards more quantitative easing through open market operations. We also expect the RBI to cut the CRR. A critical issue is whether banks are willing to lower rates further given the rising risk aversion.

There are enough reasons to do so as well. Q3 GDP rose by less than expected 5.3%, and the full-year figure is expected to be much less than the Government's projection of 7.1%. Data on merchandise trade, manufacturing, infrastructure sector growth, tax revenues, etc. continues to be bleak. Globally, the central banks in the US and Japan have lowered rates to near zero. The Bank of England (BOE) this week cut its benchmark interest rate to 0.5% and introduced quantitative easing. The European Central Bank (ECB) too lowered its key rate by 50 bps to 1.5%. Central banks across the globe continue to maintain soft monetary policy.