Central banks across the world typically slash interest rates to revive economic growth. For instance, during the global financial crisis, most central banks cut interest rates to bolster growth.
The repo rate cut of 25 basis points on January 29 is also aimed at supporting the Indian economy’s growth, which is projected to have fallen to a 10-year low of 5.5 per cent in 2012-13.
Interest rates affect growth via two major channels — consumption and investment. A reduction in interest rates leads to higher consumption and investment, and thereby lifts GDP growth. The magnitude of the role played by interest rates in stimulating growth depends on the responsiveness of consumption and investment to a cut in rates, which in turn, is conditioned by a variety of factors.
If low interest rates were enough to galvanise a sagging economy, advanced economies that have near zero interest rates would have revived by now. Deleveraging by households and the corporate sector has hampered the effectiveness of low interest rates in spurring growth in advanced economies. In India, the situation is different; but here too, interest rate cuts alone cannot engineer a sustainable growth upturn. The responsiveness of growth to interest rates is low at this juncture.
Both consumption and investment have taken a severe beating in 2012-13. Private consumption demand growth is at a decadal low, and investments, particularly private investments, are subdued.
A Crisil Reach study (July 2012) had pointed out that nominal private investments could fall by 35 per cent in 2012-13.
Rate cuts will reduce the cost of borrowings and help stimulate consumption demand in interest-sensitive segments like durables to some extent.
However, they will be less successful in engineering a revival in investments. Crisil survey of 200 companies (accounting for 70 per cent of the market capitalisation of the companies in S&P CNX500) conducted last year identified policy inaction/lack of speedy clearances for projects as the primary cause of the current slowdown in investments.
Addressing these issues will create an enabling environment in which private investments, and hence, growth will become more responsive to interest rates cuts.
There is limited room for rate cuts in India as the inflation battle is far from over. Inflation is expected to remain at around 7 per cent in 2013-14, way above the RBI’s comfort level of 5 per cent. So deep rate cuts are ruled out.
We expect the repo rate to be cut by about 75-100 basis points by March 2014 as demand pressures on inflation have begun to ease. GDP growth is likely to lift to 6.7 per cent in 2013-14, assuming a normal monsoon. Interest rate cuts will play a marginal role in this upturn.
(The author is Chief Economist, Crisil.)