RBI Passes on More Rate Cuts to Borrowers

Posted On Tuesday, Dec 01, 2015

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RBI held its Monetary Policy Review meeting today, and as expected it left key interest rates unchanged and also maintained its “accommodative” stance; although, it comes with a bit of caution. An “accommodative” stance is where a central bank tries to stimulate economic growth by lowering key interest rates, making money less expensive to borrow.

In his speech RBI Governor Mr. Raghuram Rajan said the potential inflationary impact of the 7th Pay Commission would be viewed by RBI with caution, as also on the need to be vigilant towards the price rise in some food products going forward.

The RBI has still maintained its inflation target of around the 5.0% mark in March 2017. If you would recollect, the RBI’s inflation target now is 5.0% by Jan-Mar 2017. Given the factors laid above and the impact of increase in service tax in the next budget, it would be a great challenge to meet the 5.0% target.

We thus hold our view that the next rate cut (25 bps) would be possible only post the Budget. With the RBI highlighting the impact of Pay Commission on the fiscal numbers, it would want to wait and see the markets’ response to the Government’s ability to meet the 3.5% Fiscal Deficit target. If the market senses that the Budget numbers are credible and the Government has resources to meet the 3.5% target, it would improve investor confidence and the RBI will be able to utilize the limited space available to cut rates to 6.5%. Any reduction in interest rates post that would depend on the RBI achieving the 5.0% inflation target.

Transmission of rates by banks
More than the quantum of rate cuts the RBI should now focus all its energy on improving the transmission. The RBI has cut rates by 125 bps since January but total lending rate cuts by banks have been less than 60 bps. For the economy to benefit from the low inflation and monetary accommodation; lending rates have to fall more, and quickly.

Even in the bond markets, post the fall seen in 2014 in anticipation of rate cuts; the bond yields haven’t fallen by much as supply outstrips demand.

In an accommodative cycle, the liquidity situation has to be remain plentiful for the banks’ cost of funds to fall and which banks can pass on to the borrowers. Data that we maintain shows us that Core Liquidity (liquidity directly managed by the RBI) which was surplus to the tune of INR 800 bln in August 2015 has turned into a deficit of INR 250 bln in November. The RBI needs to ensure that Core Liquidity swings back into surplus so as to ensure that banks can pass on the benefit of lower cost of funds by cutting lending rates. As foreign inflows have dried up the RBI will have to resort to buying Government bonds to infuse durable (long term) liquidity.

Takeaways for you
RBI has promised to come up with a new methodology for banks to determine the base rate for loans based on the marginal cost of funds. Once this is implemented, all banks would move to the new system and this would help in better transmission of policy rates into lending rates. Then borrowers can look forward to lower EMIs on their loans. Also the Government is examining linking small savings interest rates to market interest rates, which will again lead to better transmission of rates to end users.




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Above article is authored by Quantum.

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