Wednesday, September 30, 2015

What explains RBI's surprise rate cut?

The RBI's rate cut of 50 basis points was a huge surprise to everybody. I would have thought the market reaction would be ecstatic. It hasn't quite been that although the market indices have risen. I argued for a 50 bp cut in an article in the Hindu (Hemmed in by the safety net) on September 28 but did not expect the RBI to oblige.

So, what caused the RBI governor to change his mind?

Many analysts point to the global economy, the inflation rate being within the 6% target for January 2016 and the downward revision in the growth rate for India to 7.4%. And yet, none of these was seen as influencing the RBI in the run-up to the budget. It's also hard to buy the contention that the RBI has tilted in favour of growth: the governor is sticking to the glide path for inflation and is setting his sights on bringing inflation down to 5% by 2017. That being the case, the RBI would have been more comfortable delivering a cut of just 25 bp. Why a 50 bp cut?

My guess is that the steep cut has to do with the NPA and capital position of public sector banks. The woes of the steel industry have been added to those of the infrastructure sector and there's no let up in pressure on the NPA front. There's only so much additional capital the government can provide. However, banks are holding to excess SLR securities- around 29% of liabilities against the mandated 21.5%. A rate cut boosts the value of these holdings and gives capital gains to banks. This helps them make provisions against growing NPAs. In the process, the rate cut does provide  a stimulus to the economy and especially to retail credit.

If the market response has been somewhat tepid, it could be because it's hard to conclude that this is the beginning of a round of rate cuts. Instead, as the governor mentioned, the RBI has front-loaded rate cuts, delivered these at one go. It's unlikely that there is much more to look forward to in the year ahead, especially if the Fed rate hike comes through.

We need to get growth over 8%. It would have helped if the governor had reiterated his commitment to the 6% target for January 2016 and omitted any mention of a target for 2017. That he did not do so suggests that bringing down inflation further remains the priority.


K.R.Srivarahan said...

Sometimes some of us suffer from 'Surprise Bias', an urge to create surprise. Central bank governors do not like predictability of their actions. I wonder if these two psychological factors were involved.

Anonymous said...

Hi Prof.,
Nice blog. Some of the commentators have also raised a flag over deposits getting affected and People moving the savings to physical assets. So new deposits may be difficult to mobilize.

This apart from the new models of banking that have been introduced which is to bank to the unbanked. The established banks might find it difficult.

A CRR cut would also have been good.

- deeps

T T Ram Mohan said...

Mr Srivarahan, Yes, central bank governors do like to surprise but they need to be seen to b consistent in their actions as otherwise their credibility gets eroded. In the present case, most analysts see the RBI's action as not consistent with recent pronouncements.

Deeps, yes, lowering the rate does impact deposits but, at the present level of credit growth, this should not be a problem.