How Low Can Interest Rates Go In India?
With the Indian government’s Rs 20 lakh crore economic package likely to provide limited fiscal support to the economy, the onus now shifts back to monetary policy.
A rapid collapse of growth, and the expectation that inflation will remain in check, is seen prompting India’s Monetary Policy Committee to cut rates once again when it meets in June. At 4.4 percent, the repo rate is already at its lowest. The reverse repo rate at 3.75 percent is marginally higher than what it was in the aftermath of the
global financial crisis.
Still, economists expect steep rate cuts ahead.
Pranjul Bhandari, chief India economist at HSBC, expects the MPC to cut rates by 40 basis points in June. Rahul Bajoria, chief India economist at Barclays, expects the committee to cut rates by 50 basis points in June, followed by a cut of 40 basis points in August. Prachi Mishra, chief India economist at Goldman Sachs, also expects another 100 basis points in rate cuts between now and the third quarter.
That would take the repo rate down to 3.4 percent. If the current 65-basis-point corridor between repo and reverse repo rate is maintained, the latter would move down to 2.75 percent.
The Taylor Rule
What are the factors that will determine how low policy rates can go in India?
One commonly used equation to determine this “terminal interest rate” is the ‘Taylor Rule’, first proposed by economist John Taylor in 1993. One of the variations of the Taylor Rule uses an equation based on the real interest rate; the difference between the current level of inflation and the targeted level of inflation; and the output gap, which is the difference between the current level of output and the potential output.
Going by that rule, what would be the terminal interest rate in India amid the current conditions?
Abhiman Das, RBI Chair Professor In Finance and Economics at the Indian Institute of Management-Ahmedabad, said that in the face of an unprecedented output loss, the standard Taylor Rule framework is difficult to apply. However, this is how Das sees the emerging interest rate scenario:
- While guessing the output gap is fraught with uncertainty, what is certain is that it is sizeably negative. Both actual and potential growth have fallen sharply.
- At the same time, the inflation gap has remained positive and expected to be so at least for a quarter.
- Therefore, within the Taylor Rule framework, you would give much higher weight to the output gap relative to the inflation gap.
- If you assume a real interest rate of 1.5 percent, an output gap of -2 percent and an inflation gap is 2 percent, then, with a respective weightage of 0.9 and 0.5, the standard Taylor Rule would predict a short run interest rate as low as about 1 percent.
The ‘Positive Real Rate’ Philosophy
The other broad rule of thumb used for determining the appropriate level of policy rate is that inflation-adjusted real interest rates should be positive.
While India does not have a formal real interest rate target, former RBI Governor Raghuram Rajan had suggested maintaining interest rates at about 1.5 percent.
Inflation-adjusted interest rates are already negative, said Bajoria. In the near term, high inflation is a reflection of supply dislocation and will correct itself, he said. In the interim, negative real interest rates could persist till the end of this year, he said.
There is scope to cut interest rates and run with negative real interest rates for some time, said Sanjeev Prasad, managing director and co-head of Kotak Institutional Equities, in an interview with BloombergQuint. “The immediate priority should be to revive demand, whether that happens through the monetary route or fiscal route or some combination of that,” he said.
Ananth Narayan, associate professor of finance at SP Jain Institute of Management and Research, also said the usual implications of negative real interest rates, such as a rise in inflation or a currency crisis, won’t apply in the current situation. The low interest rate environment will help both financial institutions and borrowers, he said.
Other Structural Constraints
There may be other structural constraints that could come in the of reducing interest rates or at least the effectiveness of lower rates in India.
One of these is the reliance of a large chunk of the Indian population on deposits. A cut in policy rates impacts depositor returns negatively. Equally, since retail deposits make up a sizeable part of bank funding, reducing rates below a certain level may be counter-productive for the banking sector. A pool of small savings on which rates tend to adjust more slowly also prevent banks from reducing deposit rates beyond a point and reduce the effectiveness of policy rate cuts.
To keep those deposits coming in, India needs at least “mildly positive real interest rates”, said former RBI Deputy Governor Rakesh Mohan in a conversation with BloombergQuint.
Another factor at play could be foreign portfolio flows into the debt market.
The need to compensate foreign capital for exchange rate and credit risk is likely to prevent emerging economies like India from reaching a zero-lower-bound on interest rates, said Avinash Tripathi, fellow at Azim Premji University Research Centre. A sharp contraction in exports and the possibility of declining remittances from Gulf countries has increased the exchange rate risk for the foreign investors. “Concerns about this, together with a general flight to safety, may result in capital outflows if the interest rate does not compensate for the additional risk,” Tripathi said.
RBI’s Wide Tool-Kit
To be sure, RBI has a toolkit much wider than just the repo and reverse repo rates to support the economy. It may employ all those in the current scenario.
The central bank might opt for other unconventional tools instead of policy rate cuts to revive the economy, given long-standing structural problems in effective transmission of policy rates, said Goldman Sachs’ Mishra in her note.