To deliver as a regulator, RBI should become a market player

What is the likely result of the Reserve Bank of India (RBI) cutting the policy rate by 25 basis points (quarter of a percentage) in the aftermath of Donald Trump leashing a hurricane across the global economy through his massive tariff changes? Plus, the RBI has signalled that it will be ready to go down that road further if things remain hunky dory.

If there is a rise in the money supply as a result of a cut in the bank rate, with everything else remaining equal (no change in the supply of goods and services), there will be an inflationary spurt. But RBI and independent experts appear sanguine that thing will remain on course, the heavens will not fall.

There are several reasons for this. Currently, retail inflation is running at an over two-year low. So, there is some space to play around with. Secondly, meteorologists are predicting that the country will get a good southwest monsoon which will bring home a good kharif harvest. This will handsomely raise the agricultural output and the national GDP, taking it up by a notch. This is needed as the financial year 2025 is projected to slow down to 6.2 per cent, a four-year low after reaching 8.2 per cent in financial 2024 after leaving behind Covid.

In particular, it will put additional money into the hands of the huge army of farm-wagers and small-holders. They will go out to buy such essentials that they had been postponing, upping the demand across the board for non-luxury manufacturing units (affordable two-wheelers and not-posh cars), thus giving another boost to the GDP.

At the end of the day, if the global economy does not collapse because of the US tariff mayhem, the Indian economy should be able to regain some of the bit it had recently lost in terms of GDP growth. The other positive for India is it remains a mostly self-contained economy, with low gains from engaging with the global economy, like say Vietnam and Malaysia.

The rise in GDP for the economy, insulated from the global turmoil, will cause less focus on income from foreign trade and services and foreign investment. Foreign reserves will likely go down a bit, but that will be bearable as they are now at a high of $600 billion-plus or 11 months’ imports.

While the rate cut is likely to be beneficial to the GDP growth and the overall economy, the banking sector may be going into a bit of ambivalence as its funding costs keep rising and rate cut takes effect. While banks will have to keep living with general rising costs, they will need to take cognisance of the rate cut promptly.

Large borrowers will force banks to cut their lending rates promptly, putting pressure on banks’ earnings. In response, banks would want to promptly lower their costs by lowering what they pay their large numbers of depositors who make up their bulk of resources.

But that cannot be done in a jiffy. Existing fixed depositors will continue to earn their existing higher interest rates. It is only the new depositors coming in who will pay less. There will be a mismatch between what banks pay and earn. This will put pressure on banks’ earnings. This will not be good for the economy as a whole.

Things will get really complicated when it comes to housing loan borrowers. One analyst apprehends that “home loan borrowers may not see much meaningful or immediate interest rate relief. Banks have not transmitted earlier MPC rate cuts to borrowers because of higher funding costs, pressure on net interest margins, higher NPAs, and a cautious lending climate."

If banks do pass on the benefits of the last two rate cuts, it will be a boost to homebuyers, particularly for those eyeing affordable housing. But, as the saying goes, there is a big space between the devil and the deep sea.

The key issue that emerges is of ‘monetary policy transmission’. The authorities, in this case the RBI, change the policy rate in order to effect certain changes in the economy. This is done in the expectation that market players will respond to the policy changes along the logic of economic theory. But that sometimes does not happen. Then, the impact of the change in the policy does not impact on the broader economy and policy transmission is crippled.

Then, the measure of the policy change is negated. As we have heard an analyst declare, earlier changes have not yet taken place. Simply put, a bank is prompt in cutting the rate that it pays the small depositors (you and me) but slow in cutting the rate the borrowers like home owners have to pay.

We are back to incontrovertible changes like the tariff changes made by Trump and the monsoon. These are not in our hands. Once we have them on our hands, we have to do the best to live with them. The actions that work the best are those that allow the market forces to play themselves out in terms of their own logic and only push them alone a little.

One way in which the RBI can put in more liquidity is by not seeking to change policy rates, cutting them in this instance, but by simply printing more money. The RBI can buy more government paper in the market and thereby put more cash in the hands.

Another way can be to buy dollars from exports by a higher rate. This will create more liquidity, which will also provide more incentives to try and export more.

This, in fact, has been happening and the rupee has been going down against the dollar. This is also making imports costlier. Overall, the foreign reserves will go down as this has, in fact, been happening.

The effective policy rule that emerges is that the RBI should avoid issuing fiats like bank rate changes and play the market — take the market the way it wants it to. But there is a contradiction here. The regulator will not know how to play the market.

In this case, the financial regulator can get market-savvy players who will act as members of an advisory panel. But one overriding rule must emerge. The advisory panel members should not become guilty of conflict of interest — advise the regulator in the morning and themselves play the market on their own money in the afternoon!

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