Over-Rated Cuts!

Repo rates: Should RBI have gone for aggressive rate cuts to stem the slump in investment cycle?

Much ink has been spilled on the implications of Rexit and Brexit. This piece is not on any of these exaggerated Exits. That would only add to the clutter that is already clouding judgments on these. This is more on the heated debate that has ensued after the untimely exit of rock star Rajan. As can be guessed, interest rate is at the heart of this debate. Could RBI have gone for aggressive cuts and engineered a turn in capex cycle (investment demand) when opportunity presented itself in the form of lower inflation?

First, on inflation, there are two opposing views. One holds the view that the focus should have been on core inflation (non-food and non-fuel), not on the overall inflation which includes the volatile food and fuel components, which experts say, rarely respond to monetary actions. So when the core inflation fell dramatically over last few quarters (even within CPI i.e Consumer Price Index), RBI had a resounding opportunity to cut rates aggressively to stimulate growth. On the other hand, opposing view holds that what pinches the common man is the overall price rise, not just core, hence the need for unrelenting focus on the overall CPI and the rationale for RBI’s glide path target of 5%.

Without getting into the merits of which view is more appropriate for India etc, here is another way to look at the debate more clinically. Had RBI taken the core inflation argument on its face value and pushed the rate cuts aggressively, would it have helped the economy. Bit of macro munching here would help in answering this. Behind the glittering world-beating GDP headline numbers that the Govt. is flashing in its credentials, there is a stark reality that the growth is anemic on the ground, amply supported by low job growth, muted wage growth and lack of buzz. While some pockets of economy are just doing fine, economy is still not firing on all cylinders, mainly because of the continued slump in private investments. Capex turn is critical for economy to grow at its potential level of 8% (old method) or at 9+% (as per new method).  Could aggressive rate cuts have achieved this by stemming the slide in investments demand?

In triggering the capex demand, rates are only one part of the equation, that too a marginal one. Health of corporate balance sheets and utilization numbers (capacity utilization) play a much bigger role in the reversal. Sluggish global growth, ongoing deflation in commodity cycle and weak domestic demand have all come together as a crippling combo to create excess capacity in every foreseeable sector, thereby impacting the utilization across the industries. Ailing banks(NPA) and bloated corporates (leveraged balance sheets) have further added to the woes for the private investments. All these have fed to each other in a vicious cycle to conspire a deadly slowdown in investment demand. Aggressive rate actions couldn’t have helped much, unless it was accompanied by banks clean up and recovery in global demand. By not going on aggressive rate path, pain on Rupee at least has been spared by RBI.

On the eve of every monetary policy meetings, corporates have always clamored for aggressive rate cuts as a routine, knowing well the solution lie elsewhere. Given the murky outlook for global macro, esp. after Brexit and the continuing pain in domestic banks and leveraged corporates, it may be a long winter before the investment engine starts firing in full steam. Till then, rate cuts if any, can curtail the corporate clamor, but hardly can reverse the rot.