Credit Policy Note – June 2nd 2015

The credit policy was broadly in line with expectations. Some of the key features of the policy were as follows:

  • The repo rate under the liquidity adjustment facility (LAF) has been cut by 25 basis points (0.25%) from 7.5% to 7.25%. This effectively reduces the reverse repo rate to 6.25% and the bank rate to 8.25%. (The repo rate is normally a means to signal rate direction in the market. Industry keenly awaits rate cuts because it signals lower cost of funds for companies).
  • The Cash reserve ratio (CRR) has been kept unchanged at 4% of net demand and term liabilities (NDTL).
  • The statutory liquidity ratio (SLR) has also been left unchanged.

Background to the policy

There was a distinct slowdown in IIP, especially the core sector growth in the last quarter. Inflation was also down and the fiscal deficit also came in at less than 4% of GDP. This obviously created a classic situation where inflation was under control and growth was not picking up. The rupee had also depreciated during the period to the 63-64 levels to the US dollar. A small rate cut to improve asset valuations was called for to compensate for the value loss due to the depreciation of the rupee.

25 bps versus 50 bps

The major debate in the credit policy was whether the RBI should go in for a 25 bps cut in repo rate or a 50 bps cut. This debate was triggered by 3 key considerations. Firstly, there is a doubt over the monsoon shortfall this season. Estimates vary from a 7% shortfall to a 12% shortfall. A shortfall in monsoon typically means higher inflation and hence the RBI may be forced to move in and cut rates again. They have probably kept some leeway for that. Crude oil prices have also moved up after touching a low of $45 and are now in the range of $65-70. Any further rise from here will start impacting inflation.

Secondly, the GDP numbers have been disappointing in terms of the Gross Value Added (GVA). GVA shows the actual GDP growth that accrues to business and the rest is accounted for by indirect taxes. Out of the GDP growth of 7.5% last year, the GVA was just 6.1%, down sharply from around 8.4% two quarters back. This has again forced the RBI to stick to a 25 bps rate cut to keep some room if GDP continues to be under pressure.

Lastly, there is the tricky issue of foreign inflows. India has already seen an outflow of $3 billion in equity and debt in the last one month. Any rate cut is normally negative for debt inflows and the RBI would be keen to keep that buffer in case debt flows starting slowing down. Had the RBI cut rates by 50 bps and the debt inflows had come down sharply, then changing course would have been extremely difficult.

Are rate cuts being passed on?

In his previous policy, Dr. Rajan had expressed concern that commercial banks were not passing on the benefits of rate cuts to the final borrowers. That has already started and now banks are ensuring that there is no time lag between the announcement of the rate cut by the RBI and its onward transmission.

How will the markets react?

Equity markets led the correction in the market as the Nifty lost 203 points. The core issue was that the 25 bps cut had already been factored into markets. Markets were betting on Dr. Rajan to surprise on the upside by cutting by 50 bps instead of 25 bps. Hence the disappointment had more to do with the gap between perception and reality. The correction may be short-lived as banks start transmitting lower rates to industry.

The dilemma of the RBI:

The real dilemma for the RBI is two-fold. Firstly, aggressive rate cuts may not benefit industry substantially since banks are already sitting on a pile of non-performing loans. Hence, full transmission of rate cuts will be slow and with a time lag. Secondly, the RBI also needs to manage capital flows so that the macro-economy does not struggle to bridge the fiscal deficit gap. An aggressive rate cut may have left the RBI with limited options in case of a growth slowdown or an oil shock. Under the circumstances, the RBI has obviously done the best that it could.

As far as markets are concerned, once the reality of the situation dawns analysts and traders will realize that problem was not with performance but with steep expectations. As far as the rate sensitive sectors like banking, auto and real estate are concerned, the trading upgrades should commence in the next few trading sessions.

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