RBI Governor Raghuram Rajan surprised everyone by announcing a 50 basis point (0.50%) cut in interest rates, well over the 25 basis point cut the market expected. Equity markets acknowledged the governor’s move by moving sharply higher. The BSE Sensex moved from 300 points in the negative territory to a 430 point in the positive zone, a 730 point swing post the announcement. But towards the end, it corrected a bit in line with global markets.
So why is the market rejoicing? Is a 50 basis point cut the answer to all the woes of the economy?
Top Down vs Bottom Up Approach
In a recent interaction with corporate India, the government cited a lack of investment in the economy as a reason for high interest rates. If the cost of money is high, the cost of setting up projects increases, which adds to the risk of projects. Thus, lower interest rates not only reduces the cost of setting up a project but also reduces the associated risks.
However, a bottom up approach is more likely to boost the economy than a top down one. The RBI deputy governor, in a press conference pointed out that capacity utilisation in industry is around 70%, indicating that there is already extra capacity in the economy to meet higher demand. Only after this gap is reduced can we expect new capacity addition in the economy.
Lower interest rates will drive mortgage-based consumption like houses, consumer durables and automobiles. No wonder automobile company stocks, housing finance companies and those from the consumer durable stable have performed well on the bourses.
Lower interest rates reduce the cost of buying a house or any other asset which is bought using a loan. While this is true for a new purchaser, existing ones tend to benefit from lower interest rates only if their current loans are on a floating basis. People with fixed interest rate mortgages do not get the benefit of rate cuts.
This Time, the Consumers Will Benefit
As consumers increase their purchase of goods, since they now seem ‘cheap’ on a relative basis, the economy benefits. As demand-side activity picks up on account of lower rates, manufacturers gear up to meet the increased demand. This process helps in reviving the entire economy.
For the markets, companies with high debts suddenly become attractive as any reduction in interest outgo would mean more money percolating down to the profit level. Lower interest rates have a direct impact on bringing down costs across the economy.
From an economist’s point of view, lower interest rates increase demand which in turn increase inflation. But Raghuram Rajan has pointed out that he now has enough headroom to absorb the increase in inflation.
For the markets, lower interest rates offer one more advantage. As return from debt funds and similar financial instrument reduces, money is moved from these markets to equity. Savings from lower monthly instalments either tends to get diverted to consumption or the equities market.
This is not the first time the central bank has reduced rate in the current year, but this time around it is different. Earlier reduction by the central bank was not passed on by the banks to the consumer. Back then, banks were saddled with high levels of borrowers who were not capable of repaying the loans. In such a scenario, banks were utilising their profits to plug the holes.
But this time around, State Bank of India, within hours of announcement of policy rate reduction, announced a 40 basis point cut. The benefit of the central bank’s rate cut will be passed on to the economy.
And that’s a good enough reason for the markets to celebrate.
(The writer is a Mumbai-based market analyst)