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This article is more than 1 year old.

RBI achieves interest rate cut without a repo cut; but inflation fears lurk

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Hidden deep in the accompanying monetary policy report is the acknowledgement that inflation is not coming down below 4 percent at all.

RBI achieves interest rate cut without a repo cut; but inflation fears lurk
The Reserve Bank of India (RBI) has managed more bang for its buck than even the most optimistic market watchers expected. Without moving the repo rate, it has managed to spur a big rally in bond markets and the banking stocks; without moving the repo rate it has made loans cheaper for central and state governments and maybe even for corporates and home buyers. Quite a feat! But, hidden deep in the accompanying monetary policy report is the acknowledgement that inflation is not coming down below 4 percent at all; that the GDP, eighteen months hence will be just as much as it was six months back and hence sloshing so much liquidity can mean uglier inflation sometime in the near future.
But first the many positives. It’s not for nothing the RBI got a 650 point salute from the Nifty Bank index. The bond market also sent its salaams with bond prices rising between half to one percent. The big step from RBI was that it will buy state government loans via its open market operations. This is a brave decision but a tough one to pull off. Which state's bonds will it buy and where will it cut-off at the auctions. Can there be allegations or at least suspicions of favouritism? It was these fears that held back the RBI all these days from helping state government borrowings. This once it has bitten the bullet and maybe rightly so.
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The other pig fillip to the market was a higher amount of open market purchase of central government bonds. Even bigger is the sop that for the next two years (until March 2022), banks don’t have to mark to market up to 22 percent of their deposits that they invest in government bonds. This alone is enough to make banks queue up in the government borrowing auctions.
Now for the corporate sector: RBI has allowed banks on-tap facility to borrow from it at a floating rate linked to the repo rate, provided banks on-pass on the money to corporates. Which means banks can take money from RBI at below 4 percent and lend it to corporates at 7 percent, 8 percent, 9 percent whatever. A bold step to bring back the lost risk appetite of banks. There is also a small sweetener for lending to MSMEs. No extra capital even for slightly higher exposure.
But the bigger sop is for larger home loans. If borrowers bring more upfront money to buy a house, banks can keep less risk capital for those loans. Automatically, banks will lend those loans at lower rates. Traditionally, all governments and central banks try to fire up an economy by make homes affordable and home loans attractive. Because homes appeal to a person's sense of security and building more homes means more consumption of steel, cement, wood and creation of more jobs. In the Indian context, it can also relieve the glut in the luxury home segment and provide some relief to the beleaguered real estate sector. But all this will work, provided people feel confident to take loans; provided people feel sure of their jobs.
Somehow RBI itself isn’t sure all this will work so well. Which is why it stays with the consensus GDP forecasts – it estimates GDP to contract 9.5 percent this year and expand 10 percent next year. Given these subdued growth expectations, can this bold provision of liquidity create a monster of an inflation problem in a year?. Will the RBI then have the courage to quickly pull back excess liquidity, raise the cash reserve ratio (CRR) and even interest rates to put out the inflation flames? We have to see it. The RBI's praise of the government’s labour and farm policies were also a tad uncharacteristic from a central bank. Even more discordant was its entreaties to market participants to take the RBI's yield signals seriously. Hopefully, all this is nit-picking. If the RBI’s all-out push for growth works, then all sins can be forgiven.
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