Repo Rate Cut

Money Printing: Rajan Launches QE Lite to Bring Down Interest Rates

ARTS RAJAN

In the first monetary policy statement for this financial year, Raghuram Rajan, the governor of the Reserve Bank of India(RBI) cut the repo rate by 25 basis points to 6.5%.

One basis point is one hundredth of a percentage. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the short and medium term interest rates in the economy.

In the column dated March 30, 2016, I had said that it is best if the RBI cuts the repo rate 25 basis points at a time and not more.

My logic for writing this was fairly straightforward. From January 2015 onwards, the RBI had cut the repo rate by 125 basis points. In comparison, the banks had cut their lending rates by only around 60 basis points. Meanwhile, they have cut the interest rates on their fixed deposits by more than 100 basis points.

This means that the banks have cut their lending rates at a very slow pace. Hence, there was no point in the RBI cutting the repo rate by more than 25 basis points, given that the banks have not passed on that cut to their prospective and current borrowers, in the form of lower lending rates.

In this scenario the best strategy for the RBI is to cut the repo rate 25 basis points at a time and then take a check if the cut has been passed on to the borrowers by banks.

And this is precisely what Rajan did yesterday by cutting the repo rate by 25 basis points. Honestly, the cut in the repo rate was not the most important part of yesterday’s monetary policy statement.

In the most important paragraph of the monetary policy, the RBI said that it will “continue to provide liquidity as required but progressively lower the average ex ante liquidity deficit in the system from one per cent of NDTL [net demand and time liabilities] to a position closer to neutrality.”

What does this mean in simple English? There is a certain demand for money that the banking system has. But there is only a certain supply of it going around which is not enough to fulfil demand. The difference is referred to as liquidity deficit.

Hence, banks cannot borrow as much as they want to from the banking system. In this scenario they have to pay a higher rate of interest to borrow.

The monetary policy statement of the RBI puts the liquidity deficit at 1% of demand and time liabilities. This means that the liquidity deficit in the banking system is at 1% of the total current account deposits, savings account deposits and fixed deposits, of banks.

As on March 18, 2016, the total demand and time deposits of banks stood at Rs 93,786,60 crore. The liquidity deficit is 1% of this and hence works out to around Rs 93,786 crore. This is where theoretically the deficit in the banking system should have been.

But the actual deficit is more than this. Rajan in his interaction with the media after presenting the monetary policy conceded that the actual liquidity deficit was around Rs 50,000-60,000 crore more than the RBI had estimated. This means that the actual daily liquidity deficit is around Rs 1,50,000 crore.

There are multiple reason for the same. Assembly elections are currently on in several states. Around this time, the cash in hands of the public increases. As Rajan said: “you can guess as to reasons why…we also guess.” This increase is not only in the states that go to elections but also in neighbouring states.

Then there was the issuance of tax-free bonds. Further, before the interest rates on small saving schemes were cut there was an inflow of money into these schemes. All these factors have essentially ensured that the liquidity deficit in the banking system is around Rs 1,50,000 crore.

The RBI now plans to bring down this deficit to a position closer to neutrality. The RBI plans to steadily reduce this deficit. The question is how will the RBI do this? The central bank will have to buy assets from banks.

One way of going about it is to carry out open market operations and buy bonds from banks. In fact, the RBI announced an open market operation of Rs 15,000 crore, yesterday.

The question is where will the RBI get this money from? The RBI, like any other central bank, has the ability to create money out of thin air by printing it, or rather by creating it digitally these days.

And this is precisely what the RBI will do—it will print money to buy bonds. When it buys bonds, it will pay for it through this freshly created money. When this freshly created money enters the banking system, the supply of money will go up and the liquidity deficit will come down. This will push down interest rates and in the process banks will pass on lower interest rates to the end consumers.

Of course this is not going to happen overnight and will happen over the course of this financial year and perhaps even the next.

In fact, what the RBI is trying to do is similar to what happened in the aftermath of the financial crisis that started in September 2008. The Federal Reserve of the United States decided to print money and buy bonds, in order to drive down interest rates, so that people would borrow and spend more. This is referred to as quantitative easing or QE.

The RBI is also doing a smaller version of QE. We can perhaps call it QE lite.

There were other moves also to help banks lower lending interest rates. Up until the RBI had maintained a difference of 100 basis points between the reverse repo rate and the repo rate.

While repo rate is the rate at which the RBI lends to banks, the reverse repo rate is the rate at which the RBI borrows from banks. Before today, the repo rate was at 6.75% and the reverse repo rate was at 5.75%. The difference, as mentioned earlier, was 100 basis points.

The RBI cut the repo rate by 25 basis points to 6.5%. At the same time, it increased the reverse repo by 25 basis points to 6%, thus narrowing the difference to 50 basis points. Hence, banks will now pay a lower interest when they borrow from the RBI and get a higher interest when they have excess funds, which they can park at the RBI. This basically will help banks to earn more and make it more likely for them to cut their lending rates.

Further, banks need to maintain 4% of their demand and time deposits with the RBI as a cash reserve ratio(CRR). Currently, the banks need to maintain 95% of the required CRR with banks on a daily basis. This has been lowered to 90%. This will help ease the pressure on banks and they will have more free cash. This should again help them cut their lending rates.

Up until now, the RBI repo rate cuts led to interest rate on deposits being cut more rapidly than lending rates. This time around, the lending rates are also likely to be cut.

Watch this space!

The column was originally published on Vivek Kaul’s Diary on April 6, 2016

Why RBI Should Not Cut Interest Rate by 1%

 

RBI-Logo_8

In an interesting The Honest Truth column which was recently published, Ajit Dayal writes: “I think the RBI may charge ahead with a 100 basis points cut!” One basis point is one hundredth of a percentage. Hence, 100 basis points amount to 1%.

The Reserve Bank of India(RBI)’s next monetary policy statement is scheduled for April 5, 2016.

Dayal offers multiple reasons on why he thinks the RBI may cut the repo rate by 1%. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the short and medium term interest rates in the economy. I would highly recommend that you read Dayal’s column before you start reading mine.

The stock market wallahs always want lower interest rates because they believe that lower interest rates take the stock market to higher levels. The logic is that at lower interest rates people will borrow and spend more. They will buy more two-wheelers, cars, consumer durables and homes, and this will benefit companies. With this increase in consumption, earnings of companies are likely to go up, and the stock prices will adjust for it.

Further, it will also benefit companies which have a huge amount of debt. They will have to pay a lower amount of interest to service their existing debt. Third, the banks will benefit from the huge bond portfolios that they have.

As Dayal writes: “A 1% cut in interest rates would boost the value of the bond portfolios of banks by 10% to 15%. So, for every Rs 100,000 crore of bonds held by the banks, there will be a possible Rs 12,000 crore to Rs 15,000 crore surge in the net worth of the bank.”

Interest rates and bond prices are inversely related. As interest rates fall, bond prices go up. This is because investors want to stock up on bonds issued earlier, which pay a higher interest. This drives up the price of these bonds. As prices go up, this benefits banks which already own these bonds and they make higher profits.

While these reasons make sense, they present only a part of the picture. In this column, the point I will make is exactly the opposite of what Dayal is making i.e. RBI should not cut the repo rate by 1%, or at least not all at once.

There are multiple reasons for the same. First and foremost, the RBI cutting the repo rate is just a part of the process of the overall interest rates coming down. When the RBI cuts the repo rate, the banks need to pass on the cut to their borrowers as well. This happens by the banks cutting their deposit rates as well as their lending rates.

But what has happened in the Indian case is that banks have cut their deposit rates without cutting their lending rates at the same pace. As RBI governor Raghuram Rajan had said in December 2015 “Since the rate reduction cycle that commenced in January [2015], less than half of the cumulative policy repo rate reduction of 125 basis points has been transmitted by banks. The median base lending rate has declined only by 60 basis points.”

So a 100 basis points cut by the RBI will lead to banks cutting the interest rates on their deposits without cutting their lending rates at the same rate. Historically this is what banks have always done and there is no reason to believe that this time will be any different.

And this is not a good thing. Hence, it is best that the RBI cut the repo rate in a gradual way, 25 basis points at a time, wait to see whether the banks pass on the cut and then move further.

A new marginal cost based lending rate comes into the picture for banks from April 1, 2016. The RBI needs to wait to see how this pans out and whether banks actually go about cutting interest rates on their loans, as they are expected to.

Also, many economists and analysts look at interest rates just from the point of view of the borrower. But what about the saver? If the interest rates are cut dramatically the saver will have to save more to meet his or her financial goals, in the years to come. How about taking that into account as well?

Deposits with banks, non-banking companies and cooperative banks and societies, form a major part of household financial savings of Indians. In 2011-2012, 2012-2013 and 2013-2014, deposits formed 58%, 56% and 69% of the total household financial savings. Banks deposits made up for 53%, 50% and 62% of the total household financial savings. (The breakup for 2014-2015 is not available).

Hence, interest rates need to be viewed from the point of view of savers as well, given that a major part of savings are in bank deposits. The economist Michael Pettis makes a very interesting point about the relationship between interest rate and consumption in case of China.

As he writes in The Great Rebalancing: “Most Chinese savings, at least until recently, have been in the form of bank deposits…Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines, in which case rising rates should be associated with rising, not declining, consumption.”

Given that a large portion of the Indian household financial savings are invested in bank deposits, any fall in interest rates should make people feel poorer and in the process negatively impact consumption, at least from the point of savers.

Also, people who are savings towards a goal will have to save more. Pettis explains this in his book through an example that one of his students told him about. As he writes: “According to my student, her aunt was planning to save a fixed amount of money for when her twelve-year-old son turned eighteen and was slated to go university. She had a certain amount of money already saved, but not enough, so she needed to add to her savings every month to achieve her target.”

A similar logic applies in the Indian case as well and needs to be taken into account whenever we talk about lower interest rates.

Rajan has often said in the past that he wants to maintain a real interest rate level of 1.5-2%. Real interest is essentially the difference between the rate of interest (in this case the repo rate) and the rate of inflation.

The consumer price inflation on which the RBI bases its monetary policy on, in February 2016, stood at 5.2%. If we add 1.5% to this, we get 6.7%, which is more or less similar to the prevailing repo rate. The current repo rate stands at 6.75%.

The last time I used this argument some readers on the social media pointed out that instead of using the repo rate, I should have used the interest rate on fixed deposits to make this argument.

I used the repo rate because that is what the RBI does. As a February 2016 newsreport of the PTI points out: “Deputy Governor Urjit Patel also defended the RBI move to take into account the repo rate, and not the deposit rates, while computing the real rate of interest, saying the rate set by RBI is a universal one which is relevant for the entire country.”

Nevertheless, let’s take the case of the interest rate that the State Bank of India pays on its fixed deposits for a period of 5-10 years. The interest rate is 7%.

The latest consumer price inflation is 5.2%. If we to add 1.5% to this, we get 6.7%. The SBI interest rate is 7%. Hence, there is a scope for 25 basis point repo rate cut from the RBI, if we use the bank fixed deposit interest rate to calculate the real rate of interest.

The interest rate offered by SBI on a fixed deposit of a tenure two years to less than three years, is 7.5%. If were to consider this while calculating the real rate of interest, then there is a scope for a 75 basis points rate cut by the RBI.

It is important that a real rate of interest of 1.5-2% is maintained in order to drive up the rate of household financial savings. In 2007-2008, the household financial savings had stood at 11.2% of the gross domestic product (GDP). By 2011-2012, they had fallen to 7.4% of GDP. Since then they have risen marginally. In 2014-2015, the household financial savings stood at 7.7% of GDP. This needs to go up.

This column originally appeared on the Vivek Kaul Diary on March 30, 2016

The RBI rate cut won’t revive the real estate sector; lower home prices will

ARTS RAJAN
I don’t know what you want to call me, Santa Claus or hawk. My name is Raghuram Rajan and I do what I do – Raghuram Rajan, governor of the Reserve Bank of India, yesterday in a press conference

During the course of the last few weeks, anyone who had any opinion on the Indian economy was saying just one thing: “Raghuram Rajan should cut interest rates.” Given this, there was tremendous pressure on Rajan to cut the repo rate, or the rate at which the Reserve Bank of India (RBI) lends to banks.
The expectation was that Rajan would cut the repo rate by 25 basis points. One basis point is one hundredth of a percentage. He surprised everyone by cutting the repo rate by 50 basis points to 6.75%.

Or as a Facebook friend put it quoting Akshay Kumar from the movie Rowdy Rathore: “Main jo bolta hoon woh main karta hoon. Aur jo main nahin bolta hoon, woh main definitely karta hoon (I do what I say. And what I don’t say I definitely do that).”

One of the first reactions that came in on the rate cut was from Rajeev Talwar, co-CEO of DLF, India’s largest listed real estate company. Talwar said that a 50 basis points rate cut was a “pleasant surprise” from the RBI governor. He also suggested that now that the governor had “bitten the bullet”, it is time he allowed “teaser home loans…at least for a period of two years” and that would “give a huge boost to new buyers”.

The insinuation here is that high interest rates had kept people away from buying homes. Nevertheless, is that really true? Let’s take a look at what the numbers suggest. The RBI publishes the sectoral deployment of credit data every month. As per this data, the overall lending by banks grew by 8.2% between July 25, 2014 and July 24, 2015. During the same period the total amount of home loans given by banks grew by 17.8%.

How was the scene in July 2014? Between July 26, 2013 and July 25, 2014, the overall lending by banks had grown at a much faster 12.6%. During the same period home loans grew by 17.4%.

What do these data points tell us? While the overall lending growth of banks has come down, the home loans have grown at a faster rate, despite high interest rates. Further, during the last one year, 21.6% of overall lending by banks was in the form of home loans. This number had stood at 13.2% between July 2013 and July 2014.

Hence, Talwar insinuating that the real estate sector has been down in the dumps because of high interest rates, is basically all bunkum. Take the case of the State Bank of India, the largest bank in the country. Between June 30, 2014 and June 30, 2015, home loans formed around 36% of all the domestic lending carried out by the bank. And this is a huge number.

If builders had their way, they would happily turn all Indian banks into home finance companies. But the fact of the matter is that banks are already giving out a substantial portion of their overall lending as home loans.

If real estate companies are still not managing to sell enough homes and have managed to accumulate a huge amount of inventory of unsold homes, high interest rates are not responsible for it in anyway. The home loan lending by banks hasn’t slowed down one bit and continues to grow at a good pace.

The only way to revive the real estate is to cut prices. But that is something that the builders don’t want to do, having gotten used to easy money in the form of high prices over the years. Hence, they keep blaming everyone but themselves.

As Navin Raheja, chairman and managing director of Raheja Developers recently said: “I don’t think there is any further possibility of developers to reduce the price further because there is no way they can reduce the prices…If you look at it, last 10 years, there have been so many new developers which came without knowing the dynamics of the sector and later on they went into distress selling.” I sincerely wonder where this so called “distress selling” is happening, a few projects here and there notwithstanding.

The larger point here is that this sort of attitude will only hurt real estate developers in the time to come. They want to sell stuff at a price at which most people can’t afford to buy. A recent study by real estate consultant JLL points out that 69% of the unsold homes in Mumbai are priced more than Rs 1 crore. This when the weighted average price of a home in the city is around Rs 1.3 crore.

The real estate developers have refused to look at this basic fact and continue to price homes at high rates. Data from JLL shows that of the new launches that happened in Mumbai between April and June 2015, only 3.2% of the homes being built were priced between Rs 31-65 lakh. There were none under Rs 30 lakh.

As I have often pointed, the impact that falling interest rates have on EMIs isn’t huge. A  home loan of Rs 50 lakh, at an interest rate of 10% and a tenure of 20 years, leads to an EMI of Rs 48,251. At 9.5%, assuming the fifty basis point repo rate cut is passed on to the borrower, the EMI works out to around Rs 46,607, which is around Rs 1,650 lower.

No one is going to go buy a house with a loan of Rs 50 lakh, because the EMI is now Rs 1,650 lower. Also, in order to get a home loan of Rs 50 lakh, the individual interested in buying a home would need to arrange Rs 12.5 lakh for a down-payment (assuming an optimistic ratio of 80:20). Over and above this, some portion of the payment will have to be made in black as well.

What all this clearly tells us that most of what is being built by real estate developers will continue to remain unsold. The real estate developers have priced themselves out of the market. The sooner they come around to this reality, the better it will be for all of us.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on Sep 30, 2015

EMIs down by Rs 20 per lakh, we will all buy cars now

 

car
The Nobel Prize winning physicist Albert Einstein once said: “It can scarcely be denied that the supreme goal of all theory is to make the irreducible basic elements as simple and as few as possible without having to surrender the adequate representation of a single datum of experience.”

This line is believed to be the source of another quote that often gets attributed to Einstein: “Everything should be made as simple as possible, but no simpler.” Irrespective of whether Einstein said this or not, it remains a very powerful quote.

It is typically applicable in scenarios where we are trying to explain things to people. And in our zeal to explain things we end up making things much simpler than they actually are. Now take the case of the Reserve Bank of India’s decision to cut the repo rate by 50 basis points (one basis point is one hundredth of a percentage) to 6.75%, yesterday. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

This immediately led many analysts and experts who appear on television to conclude that EMIs will now fall and hence, people will borrow more and buy cars, bikes, homes, and so on. This simplistic sort of analysis you would have read by now in your daily newspaper as well.

Only if it was as simple as that.

The banks borrow deposits at a certain rate of interest. They lend these deposits as loans at a higher rate of interest. Hence, for banks to cut the interest rates at which they lend, they first need to cut interest rates at which they borrow.

Further, even if banks cut deposit rates, after a cut in the repo rate, they may not cut lending rates or they may not cut lending rates to the same extent as the deposit rates. As the RBI said in a statement released yesterday: “The median base lending rates of banks have fallen by only about 30 basis points despite extremely easy liquidity conditions. This is a fraction of the 75 basis points of the policy rate reduction during January-June, even after a passage of eight months since the first rate action by the Reserve Bank. Bank deposit rates have, however, been reduced significantly, suggesting that further transmission is possible.”

Before yesterday’s 50 basis points cut in the repo rate, the RBI had cut the repo rate by 75 basis points between January and June 2015. In response to this banks had cut their lending rates by around 30 basis points on an average. They had cut their deposit rates more.

Why was this the case? In some cases, banks were simply trying to make more money. In other cases, particularly in case of public sector banks, the banks also had to deal with a huge amount of bad loans that had been piling up. Basically banks had lent money to corporates, who were no longer returning it. In this scenario, in order to maintain their profit levels, banks decided to cut their deposit rates more than their lending rates.

Further, banks also need to compete with small savings schemes offered by India Post. Hence, they cannot cut interest rates on their deposits beyond a point, unless the interest rates offered on the small savings schemes are cut as well.

The larger point being the “transmission” as experts like to call it from a repo rate cut to falling interest rates on banks loans, is not so straightforward, as it is often made out to be.

In the press conference that happened soon after the RBI rate cut, the economic affairs secretary Shaktikanta Das said that the government would review the interest rate offered on small savings schemes like the Public Provident Fund (PPF) and post office deposits.

Soon after this, the State Bank of India cut its base rate by 40 basis points to 9.3%. The cut will be effective from October 5, 2015. Base rate is the minimum interest rate a bank charges its customers. This cut by the country’s largest bank is expected to force the big private sector banks to act as well and cut their base rates. Andhra Bank also cut its base rate by 25 basis points to 9.7%.

Hence, this time the transmission of lower interest rates after a repo rate cut is likely to be faster than in the past. Nevertheless, does that mean consumption will pick up because interest rates are now slightly lower?

Let’s do some basic maths to understand this. SBI currently offers a car loan at 10.05% to men, 35 basis points above its base rate of 9.7%. For women, the rate of interest charged is 10%.

A car loan of five years of Rs 5 lakh at 10.05% would mean paying an EMI of Rs 10,636 in order to repay the loan. With the base rate being cut by 40 basis points, a new car loan would be offered at an interest of 9.65%. This would mean an EMI of Rs 10,538 or around Rs 100 lower. Hence, for every Rs 1 lakh of loan, the EMI will come down by around Rs 20 (Rs 100 divided by 5).

So, does that mean people will now buy cars because the car loan EMI will be down Rs 20 per lakh? Does that also mean that people were earlier not buying cars because the car loan EMI was Rs 20 per lakh higher?

If the car industry is to be believed that seems to be the case. Rakesh Srivastava of Hyundai Motors told the news-agency PTI that the rate cut was a “festival gift” from the RBI. R S Kalsi of Maruti Suzuki said: “On the whole, it gives a good signal to customers. The market so far has been moving very slowly but with this (rate cut) sentiments will improve. It gives the much-needed boost to the market in the pre-festive season.”

In fact, Pawan Munjal of Hero Honda also joined the rate-cut kirtan and said: “It has come at an opportune time as it will help in raising customer sentiment during the festival season.”

Hero Honda as you would know is in the business of selling two-wheelers, motorcycles in particular. SBI currently charges 12.85% on its Superbike loan. The EMI on a Rs 50,000, three year loan, would work out to Rs 1681.1. With a 40 basis points cut, the new interest rate will be 12.45%. The EMI on this will be around Rs 1671.5, or around Rs 10 lower.

So people will go and buy bikes because the EMI is Rs 10 lower now? And they were not buying bikes earlier because the EMI was Rs 10 too high?

This sort of simplistic logic on part of corporates and analysis on part of the media, really beats me.

People will consume and buy things when they feel confident about their economic future. This will happen when they see job security and steady increments on the way. Steady increments will come when corporate profits start growing, which isn’t the case currently. Corporate profits will start growing when the corporates are able to clean up the excessive debt that they have on their balance sheets now, among other things. And all this is easier said than done.

At the end of the day, monetary policy can only do so much.

Postscript: I would also suggest that you read an excellent piece by Tanushree Banerjee, Co-Head of Research at Equitymaster, on yesterday’s rate cut. You can read the piece here

The column originally appeared on The Daily Reckoning on Sep 30, 2015

Rajan doesn’t have much scope to cut repo rate further

ARTS RAJAN
The Reserve Bank of India(RBI) governor Raghuram Rajan presented the first monetary policy for this financial year, yesterday. He kept the repo rate at 7.5%, after having cut it by 25 basis points(one basis point is one hundredth of a percentage) each in January and March, earlier this year. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.
Rajan further said that “going forward, the accommodative stance of monetary policy will be maintained.” This meant that the RBI would continue to bring down the repo rate subject to a few factors.
First, Rajan said that the banks had not passed on the earlier cuts in the repo rate to the end consumers by cutting their base rates or the minimum interest rate a bank charges its customers. Without this happening there is no point in the RBI cutting the repo rate. (In a column earlier this month I had explained why banks are not cutting their base rates. You can read it here).
Secondly Rajan said that “ developments in sectoral prices, especially those of food, will be monitored, as will the effects of recent weather disturbances and the likely strength of the monsoon.” The northern part of the country has seen unseasonal rains and that has led to rabi cop being damaged. This is expected to push food prices up. Governor Rajan wants to monitor this for a while and see how it pans out, before deciding to cut the repo rate further.
Third, the RBI is watching what the government is doing on the policy front to “ to unclog the supply response so as to make available key inputs such as power and land.” And fourth, the Rajan led RBI is watching “for signs of normalisation of the US monetary policy”. This essentially means that the RBI is closely observing as to when the Federal Reserve of the United States, will start raising interest rates in the United States.
Depending on how these factors play out, the RBI will decide if and when to cut the repo rate further. But the question is how much room does the RBI have to cut the repo rate any further? Rajan has often said in the past that he wants to maintain a real interest rate level of 1.5-2%. Real interest is essentially the difference between the rate of interest (in this case the repo rate) and the rate of inflation.
The current repo rate at which the RBI lends stands at 7.5%. In the monetary policy statement released yesterday RBI said: “The Reserve Bank will stay focussed on ensuring that the economy disinflates gradually and durably, with CPI inflation targeted at 6 per cent by January 2016.”
If we consider the rate of inflation of 6% and add a real rate of interest of 1.75%(the average of 1.5% and 2%) to it, we get 7.75%. The current repo rate is at 7.5%, which is 25 basis points lower than 7.75%.
What if, we consider the latest rate of inflation as measured by the consumer price index? For the month of February 2015, the inflation stood at 5.4%. If we add 1.75% to it, we get 7.15%, which is lower than the prevailing repo rate of 7.5%. If we add 1.5% to the prevailing rate of inflation, we get 6.9%, which is sixty basis points lower than the prevailing repo rate of 7.5%.
What both these calculations clearly tell us is that there is not much scope for the RBI to cut the repo rate further. At best it can cut the repo rate by another 50 basis points. This is assuming that Rajan maintains his previous stance of maintaining a real interest rate level of 1.5-2%.
As of now there is no evidence to the contrary. As Rajan had said in September 2014: “Have we artificially kept the real rate of interest somehow below what should be the appropriate natural rate of interest today and created bad investment that is not the most appropriate for the economy?”
This is a very important statement and needs to be dealt with in some detail. Look at the accompanying chart.
The government of India between 2007-2008 and 2013-2014 was able raise money at a much lower rate of interest than the prevailing inflation. The red line which represent the estimated average cost of public debt(i.e. Interest paid on government borrowings) has been below the green line which represents the consumer price inflation, since around 2007-2008.
And if the government could raise money at a rate of interest below the rate of inflation, banks couldn’t have been far behind. Hence, the interest offered on fixed deposits by banks and other forms of fixed income investments was also lower than the rate of inflation, between 2007-2008 and 2013-2014.
This essentially ensured that household financial savings fell from 12% of the GDP in 2009-2010 to 7.2% of the GDP in 2013-2014. As the rate of interest on bank fixed deposits was lower than the rate of inflation, people moved their money into real estate and gold. Household financial savings is essentially the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance etc.
If the household financial savings rate has to be rebuilt, the rate of interest on offer to depositors has to be significantly greater than the rate of inflation. Given this, a real rate of interest of 1.5-2% that Rajan has talked about makes immense sense, if household financial savings need to be rebuilt all over again.
And if a real interest rate of 1.5-2% has to be maintained then the RBI doesn’t have much scope to cut the repo rate further—around 50 basis points more.

The column originally appeared on The Daily Reckoning on April 8, 2015