There is a growing voice that the repo rate needs to be cut; and this message also comes from some of the minutes of the Monetary Policy Committee (MPC) meeting. The advocates of a rate cut have also reiterated that when inflation is high due to food inflation, a high repo rate cannot quite bring down prices of food items. Therefore, logically, the focus should be on growth which could be under pressure.
he important point here is that the MPC has been mandated to target headline inflation at 4% within a band of 2%. This target is cast in stone and bringing in any other consideration may be viewed to be outside its mandate. So, if one wants to leave aside food inflation it would mean going back to the mandate and changing it. There are talks of revising the composition of the consumer price index, which is fair enough. Once done the weights would change, and if food has a lower weight it should reflect in the overall index.
Now, the Reserve Bank of India (RBI) did consciously deviate from this mandate during Covid-19 when it did everything to support growth that in turn would help preserve employment in tough times. So, an exception was made when the repo rate was lowered to 4%. With conditions being normal, it would be hard to justify the stance of doing everything to support growth. Besides, it is generally argued that growth is stable and that the 5.4% number for Q2 was a blip. The projection for GDP growth is still in the range of 6.5-7%, a far cry from the negative growth rates during Covid. Also considering India remains the fastest-growing large economy, the justification of rate cuts to support growth is not fully in place.
The next question to ask is whether cutting the repo rate actually increases lending and hence growth. The theoretical argument is that lower policy rates make banks lower lending rates and industry borrow more to invest leading to higher growth. But in reality, it does not work in this simplistic manner.
The RBI has been publishing what is called the weighted average lending rate (WALR) on fresh loans since 2015-16. This rate is more relevant from the point of view of borrowers as it reflects the actual cost of funds and normally tends to be lower than the quantum of repo rate change. In this nine-year period, on two occasions growth in credit increased when the WALR declined. In 2017-18, the increase in credit growth was 13.3% as against 10% in 2016-17, while in 2021-22 it was 8.6% compared with 5.6% in the previous year. There was otherwise a direct relation between the two.
Interestingly during FY20 and FY21 the WALR came down by 160 basis points (bps) and credit growth was 6.2% and 5.5% respectively. And once the repo rate was hiked following the Ukraine war, the WALR rose cumulatively by 148 bps. Yet credit growth spiked by 15% and 20.2% in FY23 and FY24. This is not surprising because industry does not borrow merely because interest rates are low. Credit is linked to a purpose which is always related to demand. Companies borrow when they need to expand capacity as demand increases. If demand growth is sluggish, there is less incentive to borrow. After all, borrowing and not using the machinery to generate output does impact profitability. This also applies for the retail segment, which has borrowed a lot post-Covid as there was pent-up demand for automobiles and homes as well as consumption that led to more leverage. The cost does not matter here.
An interesting part of the lending cycle is that normally most loans are on floating interest rates. This means the interest rate is reset periodically. These rates are based on either the marginal cost of funds-based lending rate or external benchmark lending rate which can be the repo rate or a government security. As loans are now on floating rates, when anyone takes a loan the rate will vary every year depending on the resets. Hence, the cost will fluctuate during the entire tenure of the term loan. The current interest rate would apply only for the time period when the repo rate is unchanged.
The history of the repo rate shows there are almost the same number of increases and decreases as it varies with the inflation rate. Since 2010 it was raised 23 times and decreased 18 times. The argument that companies don’t borrow because interest rates are presently high is not convincing. Besides, if the economy is doing well and demand is robust, the higher interest cost can be absorbed (the ratio of interest cost to turnover varies from 2-5% in non-finance industries) or passed on. Therefore, to assume that lower interest rates are necessary for credit to increase or for investment may be misplaced.
This also raises the issue of the ideal repo rate. There are studies which talk of a real rate of 1.5-2%. This is something that has to hold over a longer period and not on a monthly basis. Hence if we are targeting 4% inflation, a repo rate of 5.5% or 6% looks fair. But inflation in India tends to be in the region of 4.5-5%, in which case the range of 6-6.5% seems appropriate.
Monetary policy always triggers debate as theoretical arguments on both sides — repo rate induces investment or repo rate lowers inflation are equally strong. If one were a monetarist the inflation argument would be compelling. A Keynesian would pitch for the growth paradigm. Ultimately it is a judgment call taken by the MPC with a lot of subjectivity coming in. This makes the exercise extremely interesting.
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