Given his predilection for surprising the markets, the Reserve Bank of India governor’s move to slash the repo rate by 50 basis points is a big boost for the markets and the economy. Though recent developments such as the Fed deferring its rate hike and domestic inflation moving lower than the RBI’s targeted rate for January 2016 provided Raghuram Rajan with some elbow room, the bold decision is welcome on several counts. For one, a rate cut will help banks push both investment and consumer demand, giving the economy a lift. Risk-aversion among banks and leveraged balance sheets of companies have been holding back investment; slashing rates will, to a certain extent, make new projects more attractive and induce India Inc to borrow more and up its capital spending. By shedding its cautionary tone on inflation and going beyond the predicted rate cut of 25 basis points, the RBI has sent strong signals to banks to hurry up with their transmission of lower policy rates to borrowers.

Banks have been tardy about passing on the full benefits of RBI’s rate cuts. But now, they will have few excuses to hold their lending rates much further. The recently proposed guidelines for banks to calculate their base rate based on their marginal funding cost, if implemented from April 2016, will also force banks to cut rates more sharply — which is what the central bank has wanted all along. The RBI has also prevailed on the Centre to ensure that the transmission of policy rates happens in its entirety this time around — perhaps indicating that a tacit pressure on public sector banks to start cutting rates may not altogether be inappropriate. The Centre’s resolve to remain fiscally prudent and review rates on small savings schemes has also paved the way for rates to trend lower on a sustainable basis.

In today’s environment, a rate cut may be necessary to stimulate investment, but it is not sufficient to guarantee either huge spikes in credit offtake or big increases in capital spending. Heightened uncertainty and deteriorating business confidence have played a greater role than swings in interest rates in this period of investment slowdown. To kick-start fresh investments, the Centre will have to ensure that capital locked up in older projects starts paying dividends. The RBI has also been quite right to doggedly stick to its battle to tame inflation. With inflation trending lower, real interest rates have now, after a very long time, stepped into the positive territory which will induce savings and provide a fillip to investments. For the RBI to continue with its rate cuts, the Centre will have to persist with its initiatives around inflation and fiscal consolidation. Only when the two work in tandem will sustainable growth recovery become a reality.

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