Demonetisation, dwindling growth prospects: RBI most likely to cut repo rate by 25 bps today

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Most economists expect the Monetary Policy Committee (MPC) to go for a token 25 basis point (bps) cut in the repo rate later in the day (Wednesday) unveiling the fifth bi-monthly policy announcement. One bps is one hundredth of a percentage point. If a quarter percentage point cut happens, the rate at which the Reserve Bank of India (RBI) lends overnight funds to banks will come down to 6 percent. But, some economists even bet for a steeper 50 bps cut considering the slowdown fears in the economy in the aftermath of government’s demonetisation exercise.
Since January 2015, the RBI has slashed the repo rate six times by a cumulative 175 basis points, of which five came from former RBI governor Raghuram Rajan. Thus, for the current central bank governor Urjit Patel, this will be the second rate cut announcement since he took over charge from Rajan on 4 September.

In its bid to push growth further, the government has been pushing RBI to cut rates all along, but this time there is even more compelling reason to lower rates since the demonetisation exercise being implemented by the government would likely inflict more pain on the economy in the approaching quarters.

The decision to ban notes from 8 November mid-night sucked out 86 percent of the currency in circulation leading to deep slowdown fears in the economy. While the recent data showed GDP in the July-September quarter grew at 7.3 percent, the number was still below economists’ estimates. However, experts opine the growth could definitely take hit in the ensuing quarters because of subdued spending. Also, there is no sign of investment activity picking up yet.

The cash crunch followed the demonetisation that has also caused considerable pain on the ground. Small traders, construction workers, services sector, perishable goods market are all hit due to the ongoing cash-crunch. The activities in the informal sector have come to a standstill given that, even on conservative estimates, close to 70 percent of India lives on cash economy.

The recent PMI data, the first set of economic indicators after the demonetisation exercise, showed a decline to 52.3 in November compared with 54.4 in October. Though, theoretically, a number above 50 is growth-positive, what it indicates is a slowing trend ahead.

Services PMI also fell even more sharply to 46.7 in November from October’s 54.5, the first time since June 2015 that the index has gone below the 50 mark that separates growth from contraction. It was also the biggest one-month drop since November 2008, just after the collapse of Lehman Brothers triggered the global financial crisis.

Besides the demonetisation impact, falling inflation too gives comfort to the MPC to cut rates. The CPI inflation in October dropped to a 14-month low at 4.2 percent. With good monsoon rainfall this year, analysts expect the inflation to cool down further, enabling the MPC to signal lower interest rates in the banking system.