Muted response to rate cut
Either the cut had been discounted, or smart money doesn’t see the stimulus as adequate
The Monetary Policy Committee (MPC) took the plunge and reversed stance. It cut the policy rate by 25 basis points and switched stance from “calibrated tightening” to “neutral”, which means it will pump more money into the bond market. The stock market barely twitched through the policy review session. The bulls were hoping for a 50 basis points cut. The rupee strengthened marginally.
The MPC has a good case. Inflation hit 18-month lows in December and the RBI estimates some sort of growth slowdown at the moment, given trends in high-speed indicators like auto sales. Low inflation and growth slowdown both suggest a looser monetary policy.
The extraordinarily low inflation is almost entirely due to food prices going negative. Crude prices also dropped in December. Both those price baskets are volatile. Takeout food and fuel and core retail inflation is at 5.6 per cent. That’s also down from November levels but it’s close to the high end of the RBI’s tolerance of 6 per cent.
So the Consumer Price Index (which the Reserve Bank of India is mandated to follow) may be underestimating inflation. Even so, inflation is low. If food prices don’t suddenly jump and crude prices stay more or less stable, the rate cut is reasonable.
Rates cuts are supposed to stimulate business activity. The big question mark is, will the rate cuts be transmitted through the system to benefit commercial borrowers? This may be unlikely. Public sector banks (PSBs) remain in poor shape and cannot afford to cut lending rates. They are braced for a new bout of farm loan waivers.
The bond market is braced for huge government borrowings. Government debt is, by definition, safe, if relatively low-yield. It can be subscribed to by banks that are within the Prompt Corrective Action (PCA) mechanism, or skating on the edge of PCA. That’s where the PSBs and debt mutual funds will be focussed.
The government is going to overshoot its fiscal deficit targets considerably. If all the accounting jugglery and late payments of food subsidies, etc, are adjusted for, the central fiscal deficit could well rise beyond 4.5 per cent. The states will also borrow more in an election year. Those government bonds and T-Bills will crowd out commercial borrowings.
The mutual funds are also nervous about the potential for defaults. After IL&Fs, the allegations of a scam in DHFCL and the move by RCom towards bankruptcy have left debt mutual funds feeling exposed and nervous.
The new dispensation at the RBI is apparently going to look the other way at banks keeping a large differential between borrowing and lending rates. The decision that all floating rate loans would be benchmarked to an external rate is now being passed off as a “draft”. That might help banks gouge a higher NIM at the expense of borrowers.
It’s still not clear if the PSBs have genuinely started to cut down on their non-performing assets (NPAs) burden. Nor are there signs that due diligence has improved substantially. Recapitalisation is behind the curve and it’s not obvious where the government can find the money to complete this process.
According to a new report from India Ratings, up to ~3.5 trillion of standard loans could turn into fresh NPAs over the next two years. The telecom sector remains under stress. So does real estate. The dimensions of the non-banking financial services crisis are not yet clear. The Insolvency and Bankruptcy Code is not working as quickly as it could.
This is where the real problems for the RBI may lie. It has to open the taps, given low inflation and low growth. But banks are not in a position to pass on those rate cuts and government borrowing will crowd out commercial demand for loans. This means that the growth stimulus from the rate cuts will be low.
Banks may pick up a fresh sequence of NPAs and, if growth and profitability don’t improve, corporate loans currently classified as standard could also turn into NPAs. This could mean another round of banking crises.
The stock market’s muted response to the rate cut can be viewed in many ways. First, the cut had been discounted by many participants and some were hoping for bigger cuts. So there was some bull unloading. Second, the smart money doesn’t see the stimulus as adequate.