Explained: Why RBI's repo rate cuts are not enough to bolster GDP growth

Transmission of rate cuts by banks has been slow because any lowering of interest rate, with deposit rates unchanged, will reduce banks' net interest income spread, affecting their revenue.

Business Standard : In order to boost the country’s sagging economy, the Reserve Bank of India’s (RBI’s) monetary policy committee, holding its fifth bimonthly meeting from Dec 3 to 5, is widely expected to again cut the key repo rate by 25 basis points (bps).

Official data released by the government last week showed that India’s gross domestic product (GDP) growth in the July-September quarter of 2019-20 slowed to a 26-quarter low of 4.5 per cent, on a year-on-year basis, for a number of reasons. Weak manufacturing growth, a fall in consumer demand and private investment, and lower exports due to a global slowdown were cited as some of them.

For its part, the RBI has lowered the repo rate — at which commercial banks borrow from it — by a cumulative 135 bps so far this calendar year to 5.15 per cent, the lowest in nine years. Even so, there has been little recovery in the economy during this period. Let’s understand why.

Relation between interest rate and GDP

For any bank, its net interest income (NII) — the difference between the interest it receives on loans given and the interest it pays on deposits — is the main source of its revenue.

A change in lending rate affects the cost of raising funds in the economy. For instance, a cut in lending rate makes loans cheaper. This prompts industrialists to borrow more for, say, capacity expansion (investment), and households for private consumption. This has a direct bearing on the country’s GDP, which, by definition, is the sum total of private consumption, private investment, government investment/spending, and net exports.

However, any cut in banks’ lending rate, should they continue paying interest on deposits at the same rate as before, would reduce their NII spread. That would have a negative impact on their revenues. So, that should explain why banks have shied away from transmitting RBI’s repo rate cuts to borrowers in the form of lending rate cuts.

During its fourth bimonthly review in October, the MPC noted that policy “transmission has remained staggered and incomplete”. In response to a 110-bp cumulative cut in repo, the weighted average lending rate cut on fresh loans had been only 29 bps, it said.

RBI faces calls to do more than just one rate cut amid economic slowdown

Finance Minister Nirmala Sitharaman has ratcheted up pressure on the six-member monetary policy committee for a 'significant cut' to lift economic growth from a five-year low.

Business Standard : India's central bank is poised to deliver its fourth successive quarter-point interest rate cut on Wednesday, amid calls from investors and the government for further easing as a slowdown gripping the economy becomes more pervasive.

The Reserve Bank of India will lower the benchmark repurchase rate by 25 basis points to 5.5 per cent, according to almost all of the 36 economists surveyed by Bloomberg.

Swap markets are pricing in at least another 50 basis points of reductions before the end of 2019.

Finance Minister Nirmala Sitharaman has ratcheted up pressure on the six-member monetary policy committee for a "significant cut" to lift economic growth from a five-year low.

Inflation that's stayed below the central bank's 4 per cent medium-term target for 11 months in a row and the Federal Reserve's first rate cut since the financial crisis allows room to retain the policy makers' easing bias.

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A quarter-point cut will take the benchmark rate to the lowest since April 2010. With price pressures anchored, the central bank may have the leeway to keep rates lower for longer.

"We expect 75 basis points of additional rate cuts spread over August, the fourth quarter of 2019 and the first quarter of 2020, taking the repo rate to 5 per cent by March 2020," said Pranjul Bhandari, chief India economist at HSBC Holdings Plc in Mumbai. The headline inflation will stay below the RBI's medium-term target for the "foreseeable future" due to a lack of underlying price pressures across sectors, she said.