Context:

The Reserve Bank of India (RBI) cut key interest rates for the fourth time this year as it strives to boost corporate investment and consumer spending to accelerate stubbornly slow economic growth, which it now expects will not exceed 6.9% in the current financial year, as both domestic and external demand stay weak.

A cut of 35 basis points in the repurchase, or repo rate, at which the central bank lends funds to commercial banks, took the cumulative reduction since February to 1.1 percentage point. One basis point is one-hundredth of a percentage point. The repo rate is now 5.4%, the lowest in nine years.

Repo rate and Reverse repo rate:

Repo and Reverse repo are short for repurchase agreements between the RBI and the commercial banks in the economy.

In essence, the repo rate is the interest rate that the RBI charges a commercial bank when it borrows money from the RBI.

As such, if the repo falls, all interest rates in the economy should fall. And that is why common people should be interested in the RBI’s monetary policy.

Investments depend essentially on the “real” interest rate. The real interest rate is the difference between the repo rate and retail inflation.

Reasons for Consecutive Rate Cuts by the Central Bank:

RBI has been the most aggressive central bank in Asia in cutting interest rates this year to boost growth from a five- year low of 5.8% to which it sank in the quarter ended March and spur investments.

Finance minister Nirmala Sitharaman had called for “significant” policy easing by the central bank to help revive growth, which slumped in the March quarter to a five-year low of 5.8%.

The RBI said various high-frequency indicators suggest weakening of both domestic and external demand conditions.

Domestic economic activity continues to be weak. Private consumption, the mainstay of aggregate demand, and investment activity are sluggish.

To address the growth concerns, reducing the cost of capital is essential.

The Business Expectations Index of the RBI’s industrial outlook survey showed muted expansion in demand conditions in the second quarter, although a decline in input costs augurs well for growth.

Global slow-down is clear. There are escalating trade tensions, allegations about currency manipulations.

When making an investment decision, it is this interest rate that matters. As a variable, it allows an investor to compare the attractiveness of different economies.

For Effective Monetary Transmission: Rate Cuts need to transmit to real Economy by Banks:

Repo rate reductions only provide enabling conditions to reduce the cost of borrowing. To be effective, adequate transmission needs to take place.

Initially the banks were slow to ensure monetary transmission. Out of the 75 basis points cut in the past three policies, banks passed on just 29 basis points.

The reduced repo rate applies only to new borrowings of banks. The banks cost of existing funds is higher. Of course, funding costs would eventually come down but this process would take time.

Now, the rate-cuts are being gradually transmitted to the real economy. The benign inflation outlook of around 3% provides headroom for policy action to close the negative output gap.

This “lag” in monetary policy is a key variable in determining the efficacy of any rate cut by the RBI. It could take anywhere between 9 and 18 months for the full effect of an RBI decision to reflect in interest rates across the economy.

The RBI also allowed banks to classify loans to NBFCs for agriculture, small businesses and home mortgages as priority-sector lending, in a bid to ensure credit flows to those key contributors to economic growth and employment.

The RBI is, therefore, cutting interest rates to incentivise people to consume more and businesses to invest more.

Arguably, the space for fiscal concessions is limited given the overall revenue scenario, but the government can certainly push for further reforms to incentivise investment without impacting its fiscal arithmetic.

24X7 transfers through NEFT from December:

The RBI has decided to allow round-the-clock fund transfers through NEFT from December this year in order to promote digital transactions.

The decision, the Reserve Bank of India said, “is expected to revolutionise the retail payments system of the country”.

Currently, the National Electronic Funds Transfer (NEFT) operated by the RBI as a retail payment system is available for customers from 8 am to 7 pm on all working days with the exception of second and fourth Saturdays of a month.

The NEFT system is used for fund transfers up to Rs 2 lakh.

The present economic slowdown now is part cyclical which can be addressed by a rate cut and part structural, for which reforms are an absolute necessity. Therefore, unless the government responds with its own measures, the RBI’s efforts to support growth may go in vain.

Conclusion:

RBI governor Shaktikanta Das, who became central bank chief in December after Urjit Patel resigned, told reporters that the MPC viewed a quarter-point move as “inadequate.” A half-point reduction would have been “excessive” and 35 basis-point of easing was deemed “balanced”.

Further, demand for investment and consumer durables has to increase, which is a function of income much more than the cost of borrowing.

To uplift investment sentiments, adequate momentum has to be generated by the fiscal side. Unless capacity utilization improves, investment demand from the private sector is not likely to improve.

The central bank said addressing growth concerns by boosting aggregate demand, especially private investment, assumes the highest priority at this juncture while remaining consistent with the inflation mandate.