Raghuram Rajan surprised the markets this week as he reduced the cost of money by half a per cent, a move that is likely to trigger a consumption boom in the economy. Stock and currency markets cheered the RBI Governor’s move, with Sensex, the benchmark index of the Bombay stock exchange, moving up by 2.4% during the week.
Retail inflation well below 4% provided the impetus to the RBI to cut rates. Rajan also exhorted banks to pass on the benefits of cheaper money to the borrowers, investors as well the retail consumers to boost the sluggish demand in the economy. The RBI expects CPI inflation to be 5.8% by January 2016 and 4.8% by March 2017. “If this downshift plays out, there is room for another 50 to 75 basis points rate cut in 2016,” says Sujan Hazra, chief economist, Anand Rathi Financial Services Ltd.
The RBI has reduced the interest rates by 1.25% so far in 2015 but only a third of it has been passed on by the banks to its consumers. Banks have been reluctant to lower their interest rates due to high non-performing loans affecting their profitability. “If the banks pass on benefits of lower interest rates on to their consumers then it would start the virtuous cycle in the economy,” says Deepak Kapoor, financial analyst, ADC legal. This would initially boost consumption, followed by the start of the investment cycle which our economy needs desperately. Once investment demand picks up then the bank’s concern of bad loans would also get automatically addressed, he adds.
Though many believe that demand revival and the pay-out of the Seventh Pay Commission might result in higher inflation but Angel Broking feels that the falling commodity prices, lower minimum support price hikes, a stable currency and the contingency plans made by the government to relieve supply side constraints should aid in mitigating inflationary pressures. Lower inflation and accommodative interest rates are a must to unleash a consumption boom especially in the housing and auto sectors. Kapoor says that it would take up to three quarters to see the impact of the latest cut in interest rates.
Micro, small and medium enterprises (MSMEs), known globally for their job creating potential, have been demanding lower interest rates to execute their business expansion plans. Unlike large corporates that have many avenues for raising finance, MSMEs solely depend on domestic banks to meet their financing needs.