The Reserve Bank of India (RBI) has finally begun cutting interest rates, with the repo rate, at which the central bank lends overnight money to banks, being lowered from 8.5% to 8% on Tuesday. How soon the equated monthly installments on your home and car loans decline will depend on two factors.
The speed with which the central bank brings its policy rates down and the incentive banks have to follow suit. The economy is, however, not appreciably better placed for faster monetary transmission than the last time the RBI took an easy credit stance.
Governor D Subbarao reckons the economy has slowed down considerably since he embarked on a rate tightening cycle in March 2010: gross domestic product grew by a meagre 6.1% in the three months to December 2011. And inflation, which remained above 9% for nearly two years, has moderated to 7% in March 2012. Specifically, the rate of rise in prices of manufactured goods has almost halved to 4.7% in March from a high of 8.4% in November 2011. This gives Mr Subbarao the elbow room to cut rates further to prop up economic activity without stoking inflationary pressures.
But banks stand between Mr Subbarao and the borrower. Three years ago he had a tough time cajoling them to lower interest rates in line with signals from Mint Road. In April 2009 the repo rate stood at 4.75% , half of what it was in October 2008, after a series of cuts.
Despite this, private banks were charging their prime customers upwards of 15% interest; their state-owned rivals slightly less and that too after some not-so-gentle persuasion from the government. The liquidity the RBI was pumping in then was used by risk-averse banks to lend mainly to their most credit-worthy borrower, the government. The borrowing requirement of the central government then was Rs 4.1 lakh crore, this year it is Rs 5.1 lakh crore and budget estimates are usually overshot.
Mr Subbarao has managed to push through a clutch of measures that should make interest rates less sticky on their way down. He has freed up deposit rates and abolished the prime lending rate and foreclosure penalties on home loans. This ought to deter banks from locking existing borrowers into higher interest rates while offering better deals to new customers.
Bank lending rates, tied to deposit rates, no longer have a floor in the tax-free interest rate on savings with post-offices; the government last year allowed them to float. With all these measures in place, the central bank and the finance ministry will be watching closely to see if they are sufficient to make the monetary mechanism more responsive to policy.
Expect interest rates to come down gradually. The government’s borrowing plan, fed in large measure by subsidies on fuel, is the biggest obstacle to a faster rate reduction. The government could use the slack in demand now to raise fuel prices, Mr Subbarao argues, without fanning economy-wide price hikes. The government must heed his suggestion.