The Rate Cut Is Praiseworthy But The Challenges Persist

The RBI has quite aggressively lowered the repo rate by 50 bps and reduced the CRR (cash reserve ratio) by 100 bps to lower overall interest rates in the economy and provide durable liquidity to the system. The CRR cut will release around Rs 2.5 lakh crore in 4 instalments. These were surprises for the market, as it was widely believed that there would be a 25 bps cut in the repo rate and not 50 bps. Further, with the liquidity framework in place, the CRR was not considered a possible measure, as liquidity was induced through the VRR (variable rate repos), OMOs (open market operations), and forex swaps.

What does this mean going forward? The first is that there may not be any more cuts in future, as this has been frontloaded. With the RBI targeting an inflation rate of 3.7% (with Q4 being 4.4%), for a real rate of 1.5% to be preserved, a repo rate of 5.5% looks reasonable. While the inflation rate will remain in the 3% range for longer, it must be pointed out that the inflation rate has been low largely due to the base effect and would tend to get reversed towards the latter part of the year.

But given that interest rates will move down in the coming months based on a repo rate of 5.5% (which will probably not go down further), the following could be the implications. Individuals who have taken home loans will see their interest costs come down even further, more or less on an automatic basis. Therefore, this is the right time for individuals to take loans to buy a house or a vehicle. As these loans are based on an external benchmark, which is normally the repo rate, there will be an automatic transmission of interest rates to the borrower.

The same will hold for an MSME, where loans are fixed to the external benchmark. In fact, this particular segment is one of the main beneficiaries of a declining interest rate regime, as their cost of credit comes down. Their interest rates normally tend to be higher than that of corporates, and hence the reduction of 50 bps in the repo rate gets transmitted with alacrity.

What about corporates? Companies borrow on the basis of the MCLR, which is formula driven. The major component is the cost of deposits. For the MCLR to come down, the deposit rates need to come down. Banks here do have a challenge. In FY25, there was a case of banks not being able to retain deposits as funds moved to the capital markets where returns were better. While the repo rate was at a peak of 6.5%, the banks could at best offer 8-8.25% for a certain bucket of deposits last year. Mutual funds have historically delivered returns of 10-12%, while direct equity could be in the 12-14% range. In such a situation, lowering deposit rates across the board will always be a challenge for banks. This will mean that companies borrowing on MCLR could get a lower advantage compared with MSMEs and retail loans, as the full 50 bps reduction will not be passed to all deposits.

However, the better-rated corporates have been able to access the bond market for funds where the transmission has been smoother. Typically, the corporate bond yields tend to get benchmarked with Gsec yields with a spread being maintained of 40-200 bps, depending on the rating. The Gsec yields, as well as those on treasury bills, have been declining since February, and hence, the bigger corporates have already drawn this benefit on the borrowing front.

However, from the point of view of the deposit holder, rates have already peaked in FY25, and the returns will tend to move downwards. Therefore, there is a choice which savers have to make. Either they have to continue with safe deposits or take a chance with mutual funds. While they deliver returns in the longer term, the same cannot be said in the short term, where the risk factor is high. In fact, bank deposits tend to concentrate in the less than 1 year or 2-3 years buckets, which typically give safe returns that cannot be matched for sure by the capital market when risk is adjusted. This is a call that has to be taken by the saver.

The RBI continues to be positive on growth, which is important. Post the announcement of the GDP numbers for FY25, the ministry of finance reiterated its growth forecast range of 6.3-6.8%. It does look like that, given the measures taken by the government and the RBI, there will be an upward movement of consumption and investment which will aid in maintaining the GDP growth in the 6.5% range. The challenge, however, will be to push it past the 7% mark.

The RBI has lowered its inflation forecast for the year to 3.7%, which was expected as the inflation rates have tended to be, surprisingly, on the downside. This tendency would continue due to the base effect, which is caused by prices being very high last year.

This has been a hat trick of rate cuts in an era where several central banks have been lowering rates to bolster their economies. The Fed has been the outlier so far, and logically so too. The current state of the USA is quite uncertain, given the tariff issues that are pending. This is one reason why the Fed has been more gradual with rate cuts, as the threat of inflation is real. This also has tended to keep the dollar volatile, which is tending to weaken presently. This uncertainty will persist for some more time.

The author is Chief Economist, Bank of Baroda and author of ‘Corporate Quirks: The Darker Side of the Sun’. Views are personal.