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Monday, 28 July 2014

Over to you, Delhi

India's rate cut is more challenge than help

It’s a tale of two cities. In Mumbai, the Reserve Bank of India is doing what it can to propel the Indian economy. The central bank announced a surprisingly large 50 basis points interest rate cut on Tuesday, to 8 percent. The announcement came with a thinly veiled warning to the government in New Delhi that more progress is needed on fiscal policy and reform. Investors might have been pleased with the news - the reduction was the first in three years and was twice as large as expected. But they realised that Mumbai will not come to their rescue. The benchmark SENSEX index was up less than 1 percent in afternoon trading.

To start, this cut isn’t large enough to bring down lending rates by a meaningful amount. It will only partly counteract the effect of higher deposit rates, which have risen from 7 to 9 percent since 2009. More cuts would be needed to make a difference, and those seem to depend on what happens in Delhi.

The RBI wants the finance ministry to scale back spending on fuel subsidies and other handouts, as it promised to do in the March budget. And to get investment really moving, reforms are still sorely needed. A reduction in the cost of capital won’t do much to help domestic firms overcome the key bottlenecks of shortages of land and power. That requires better regulation and greater confidence in the government’s policies.

Then there is foreign direct investment, crucial for a country running a trade deficit of 4 percent of GDP. A RBI report published last week pointed out that FDI could have been 35 percent higher than was actually received last year if the government had not increased “policy uncertainty”.

The finance minister has put considerable pressure on the RBI to cut rates. The market appears to believe that today’s action is more a result of that pressure than real conviction. The caveats offered by the RBI backs up that suspicion. So the ball’s back in Delhi’s court. It needs to go further, to show Mumbai that it also means business.

Context News

The Reserve Bank of India (RBI) cut interest rates for the first time in three years by an unexpectedly sharp 50 basis points to 8.00 percent on April 17. A Reuters poll last week had predicted a 25 basis point cut.

The central bank warned that India’s current account deficit, which widened to 4.3 percent of GDP in the December quarter, is unsustainable and will be difficult to finance, given projections of lower capital flows to emerging markets in 2012.

The markets reacted positively but movements were tempered as the central bank said that the scope for further rate cuts was limited. The 10-year bond yield of 8.38 percent was down from the previous day’s close of 8.45 percent. The main BSE index was up 0.8 percent at 1122 IST.

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