Repo rate: cut or continued pause?

 Repo Rate:
A toss between growth compulsions and ground realities

The Monetary Policy Committee (MPC) of Reserve Bank of India (RBI) will be meeting in Mumbai tomorrow (05.02.25), to review the policy (repo) rate and the monetary policy stance for the next two months. This will be the first meeting of the MPC, since Shri Sanjay Malhotra (IAS Officer:1990 Batch) took over as the new Governor of RBI on 11th December 2024.

Expectations for a repo rate reduction are high, this time, because 

  • FED Reserve reduced the rate by a full percentage point since September 2024
  • GDP growth at 5.4% in Q2FY24 was a dampener.
  • The new governor of RBI, having served as Secretary (Revenue) in the Finance Ministry, just prior to this appointment, and also as Secretary in DFS earlier, is aware of the compulsions of the government to improve the GDP growth numbers.
  • A new line of thinking is anticipated in the MPC, as out of the  total six members, all the three external members joined only a few months back and it will be the first meeting for two out of the three internal members.
  • The government's inclination towards 'consumer spend' are evident in the Union Budget presented on 1st Feb 25, especially if one looks at the changes proposed in the direct tax. with reduced tax slabs and the increase in effective exemption limit for paying 'no tax'
However the ground realities are different:
  • CPI inflation, though declined from a high of 6.21% in October 24 to 5.48% and 5.21% respectively in November and December 24, is still higher by 100 bps over the target rate of 4% 
  • The steep fall in the value of rupee to USD continues and breached Rs.87 (per USD) level yesterday. 
  • Forex Reserves, which reached a high of USD 705 Billion in 27th Sep 2024, has  dropped, since then, by more than USD80  billion.
  • FED Reserve, which reduced its rate by  1% between Sep and Dec 24, left its rate unchanged in its last meeting in % Jan 25.
My Views:

It will be prudent to keep the repo rate unchanged for now. However, if the RBI MPC decides to reduce the repo rate, the benefit may not get passed on to borrowers, whose interest  rates are linked to internal bench mark rates. In respect of external bench mark rates (EBR) also, the banks may use some of the flexibilities given in the EBR framework like (i) banks are free to decide the spread over EBR (ii) other components of spread including operational cost could be altered once in three years (EBR introduced three years back) and (iii) Interest rate under EBR shall be reset at least once in three months. 

The banks might face a "Catch 22" situation, as cutting deposit rates might result in outflow of existing deposits /less accretion of fresh deposits and non-reduction in deposit interest rates will result in reducing their NIMs still further. While repo rate reduction may propel loan growth, it will be at the cost of reduced interest rate for depositors or reduced NIM for the banks. Both are not palatable to a banker, who would not like to 

put a spoke on the source of funds or 

have reduced NIMs, especially when the stress is more than evident in the toxic personal loans, attracting additional provisions and effectively cutting down the net profit.

Whether RBI MPC will continue the pause in the repo rate till the next review in the next FY (2025-26) or yield to market/government expectations and cut down the rate by 25 bps at least? 

I am equally interested like you in looking forward to the decision of the MPC on 7th February 2025.

Regards

V. Viswanathan
4th February 2025.

Note: Rate reduction in policy rate gets transmitted easily, when the banks are flush with funds and the deposit growth rate exceeds loan growth rate. But is the transmission easy, when banks are faced with a liquidity crunch and deposits remain the major source of funds for onward lending? 

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