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

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.

Why have RBI’s rate cuts not worked for the economy?

According to economists, rate cuts have failed to boost GDP, as the present economic slowdown has been aggravated by a decline in consumption; it has not been driven by a glut on the supply side.

Sample this: During the September quarter, India’s private final consumption expenditure (PFCE) grew 5.06 per cent (at constant prices), against 9.8 per cent in the same quarter of 2018-19. Further, the manufacturing sector, which accounts for about 75 per cent of the country's factory output, contracted 1 per cent, broadly underlining that people were putting off their purchase of aspirational items like cars and televisions.

“The ongoing agrarian distress and dismal income growth so far, coupled with subdued income growth expectations in urban areas, have considerably weakened consumption demand. Even the festive season failed to revive it, and this was reflected in current data of non-food credit, auto sales and select fast-moving consumer goods,” says Devendra Pant, chief economist, India Ratings and Research.

Given the stress in real estate and manufacturing sectors, capacity utilisation in the economy since FY14 has been hovering between 70 per cent and 76 per cent — that seems to show why rate cut has not benefited India Inc, Pant adds.

Of the 70 economists that news agency Reuters interviewed recently, 24-56 economists opined that the next rate cut would marginally support growth; and nearly a third said it would have little or no impact.

Fiscal push is the way out

The way out of this slowdown could be a revival in consumer sentiment, especially in terms of income expectation. This, economists feel, should be done by addressing rural demand.

“The government should loosen its purse strings and do a massive fiscal front-loading in the economy,” says Dhananjay Sinha, chief economist, IDFC Securities.

An increase in infrastructure spending could create jobs in the rural sector, leading to a generation of demand, he says.

Media reports suggest the government could unveil a series of infrastructure projects this month as part of its plan to invest Rs 100 trillion ($1.39 trillion) in the sector over the next five years.

According to India Ratings, government expenditure picked up significantly in the September quarter. Combined capital expenditure of central and 20 states government during the quarter grew 37.8 per cent, against -18.3 per cent in the previous quarter and 11.7 per cent in the same quarter last year. Their combined consumption expenditure was up 20.1 per cent, against 4.1 per cent in the June quarter, and 14.7 per cent in the September quarter of FY19.

“We expect it to continue in the second half of FY20, leading to the central government’s fiscal deficit coming in at 3.6 per cent of GDP. If the central government adheres to the budgeted fiscal deficit of 3.3 per cent of GDP by cutting/rolling over expenditure, then the country’s FY20 GDP growth could be even lower than 5.6 per cent,” India Ratings said in a note.

That apart, the government and the RBI could benefit from a gap between retail and wholesale inflation rates, say economists. Higher food inflation in October pushed the Consumer Price Index (CPI)-based inflation above the RBI’s medium-term target of 4 per cent. Household retail inflation during the month was at a 16-month high of 4.62 per cent. But Wholesale Price Index (WPI)-based inflation hit a 36-month low of 0.16 per cent, with core inflation sliding to a 94-month low of 3.47 per cent.

An analysis by IDFC Mutual Fund, however, reveals that the current phase of divergence between WPI and CPI –based inflation rates is not driven by food and fuel which manifests lack of pricing power with manufacturers.  “If we can increase producers’ income, we can increase wage payout, and thereby improve rural demand,” says Pant of India Ratings.

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