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Will loans become cheaper? RBI faces five challenges in cutting rates

Patel and his team members at the MPC are widely perceived to keep policy interest rates unchanged as banks are flushed with cash after Indians rushed to deposit old cash during the demonetisation drive.

business Updated: Apr 05, 2017 13:40 IST
Raj Kumar Ray
RBI
RBI Governor Urjit Patel(HT photo)

Indian consumers and businessmen may be hoping for loan rates to drop further as the country came out of the painful demonetisation phase that slowed consumption and investment activity.

However, the monetary policy committee (MPC) headed by Reserve Bank of India’s governor Urjit Patel confronts at least five challenges as it starts the April policy review meeting on April 5. The policy decision will be detailed on April 6, after the two-day meeting.

Patel and his team members at the MPC are widely perceived to keep policy interest rates unchanged as banks are flushed with cash after Indians rushed to deposit old cash during the demonetisation drive.

The main risk that RBI is likely to flag is the pent-up demand as consumers starts spending money after the rapid remonetisation, which is fanning inflation.

Global factors such as the recent changes in the stance by major central banks, the movement in the US dollar, geopolitical tensions, trade restricting policies, and a possible firming up of oil and metal prices, will be discussed threadbare by RBI’s rate-setting committee.

RBI may want banks to lower lending rates further as their cost of funds has come down drastically and credit growth is crawling at 63-year low of 4.4% until mid-March 2017.

“The MPC is poised to stay on hold at its bimonthly meeting on April 5-6. Having unexpectedly shifted at the prior meeting to neutral from accommodative, it would maintain its concerns about inflation,” foreign brokerage CLSA said in a recent note.

“However, it needs to offer greater granularity to enhance investors’ conviction in its ability to achieve the ambitious inflation target of 4% over five years,” it said.

Here are the five things that will determine RBI course of action:

1. Remonetisation and inflation

While the scrapping of old Rs 500 and Rs 1,000 notes worth Rs 15.44 lakh crore, or 86% of currency in circulation, during November-December led to a mad scramble for cash, the rapid infusion of new Rs 500 and Rs 2,000 notes is stoking inflation.

Latest data showed that retail or consumer price inflation (CPI) inching up to 3.65% in February from five-year low of 3.17% in January.

The wholesale price inflation (WPI), which fell to 3.38% during the height of demonetisation drive in November, has bounced back to 6.55% in February.

In the last RBI policy review in February, RBI governor Patel had flagged concerns over inflation.

“With the remonetisation of the economy taking place at an accelerated pace over the last two months, economic activity is expected to pick up from the latter part of Q4 (January-March) of 2016-17. Discretionary consumer demand, which got impacted in the immediate aftermath of demonetisation, is expected to bounce back,” he said.

2. RBI may want banks to lower rates further

While a deluge of old notes into bank vaults has bolstered deposits by about Rs 14 lakh crore during the demonetisation drive, banks have lowered lending rates by as much as 55 bps since November, latest RBI data showed.

Moreover, the robust deposit growth of banks may continue as the Budget capped cash transactions at Rs 2 lakh while the government has been pushing Indians to go for digital payments.

“With the implementation of ban on cash transactions of over Rs 2 lakh from April 1, further decline in cash withdrawals may be a possibility,” SBI’s chief economic adviser Soumya Kanti Ghosh wrote in a research note.

Since January 2015, RBI has lowered policy lending rate repo by 175 basis points or 1.75%. Banks have lowered rates as much as 150 bps. The marginal cost of funds based lending rates (MCLR) has dropped by an average 85 bps in 2016-17.

There is still room for banks to lower rates given the fact that credit growth is crawling at 4%.

3. Oil and metal prices stay firm

Global commodity prices have remained elevated this year on expectations of faster growth in developed nations and emerging economies such as India.

Oil prices may stay firm as oil producing nations including those part of the OPEC grouping are planning to extend by six months the deal to cut oil output, which may put an upward pressure on prices. In December 2016, the oil producing nations decided to cut output by 1.8 million barrels a day.

For oil importing nations like India, the OPEC decision may lead to an uptick in inflation in the coming months.

United States President Donald Trump’s plan to step up infrastructure spending by $1 trillion and better economic outlook in Europe, Japan and India, may push up metal prices.

Oil, metals and some other imported products make up for 40% of India’s inflation basket. Even a 1% rise in the commodity prices will push up inflation by 0.4 percentage points.

4. Rupee versus Dollar

The exchange rate will play an important role in determining the inflation trajectory going forward.

After Trump assumed office in January, the dollar started gaining on expectations of tax cuts and higher government spending to spur economic growth apart from the planned Fed rate hikes.

However, the Fed in March policy review signalled that rate hikes will be “gradual”. Trump also seems to drag his feet on the fiscal stimulus. These developments have weakened the dollar in recent weeks.

The RBI is deliberately keeping the rupee firm against the dollar to temper inflation. Going forward, the exchange rate may turn volatile and increase risks to inflation.

5. Unwinding easy money policy

In the coming months, it will be difficult for RBI to lower rates significantly as the global trend is shifting towards a tighter money policy.

While the US Federal Reserve has made it clear that it may raise rates two more times after the 25 bps hike in March, the European Central Bank and Bank of Japan are also eager to unwind their easy money policies.

In such a situation, any rate cut by the RBI will only narrow the interest rate differential and accelerate capital outflows. This may weaken the rupee and stoke inflation.