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After the government’s tax cut, what are RBI’s options?

By Finserv MARKETS - Dec 25,2019
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After the government’s tax cut, what are RBI’s options?

As the government has recently given a Rs 1.45 lakh crore tax bonanza to the Indian industry by slashing the corporate tax rate and providing relief to investors on multiple counts, all eyes are back on the Reserve Bank of India. The RBI is set to decide its monetary policy next week and speculations about the possibility of further interest rate cuts are rife in the industry.

However, it’s not as simple as it looks. The banking regulator has already slashed interest rates at an unprecedented speed in this year so far. Moreover, the government’s move to let go of tax revenue of Rs 1.45 lakh crore is likely to hamper the fiscal management targets which will make the decision tough for the central bank. At the same time, there have been mixed signals from the RBI Governor Shaktikanta Das’ recent press interactions.

Let’s decode each of these issues one by one to understand what could be on the RBI’s mind as it sets the stage for a two-day monetary policy meeting.

What is the relationship of the government’s tax cut measures with the RBI?

The Reserve Bank of India has a dual objective of maintaining growth momentum and keeping inflation in check. It does so through a bi-monthly monetary policy meeting where six experts meet and vote on potential actions, the biggest of which is managing interest rates in the economy. The RBI has been cutting rates recently in view of slowing growth.

When RBI cuts its benchmark repo rate, the availability of money increases with the banks and that helps in more credit availability. More money in the hands of consumers is linked to higher demand and growth.

With interest rates coming down, many people have resumed their home-buying plans. It’s best to check for the most transparent and digital loan process to avoid hassles later and avenues such as the Finserv MARKETS portal could prove helpful with their transparency and reliability.

However, the government’s move to cut taxes has increased free cash flows for India Inc. which means that RBI may not be that hard-pressed to cut rates now that prices of products are expected to fall as companies will be looking to boost demand without worrying about their profitability situation.

Why is the RBI even considering cutting rates, then?

While it seems to be a simple argument, there are many layers to it. RBI Governor Shaktikanta Das has been saying that there’s room for more rate cuts leading many to believe that there could be another cut in the offing. However, he has also been saying that the government’s fiscal space is limited implying that RBI will be closely watching the impact of this tax bonanza on the exchequer and it would not want a situation of too much money supply in the economy which can threaten macroeconomic stability.

So, what are the RBI’s options?

In this cycle, the central bank has already cut interest rates by 110 basis points. Additionally, the regulator also asked all banks to benchmark their loans to an external rate such as the repo rate which means that the transmission of RBI’s rate actions will be better from now on. With this context, there are many who are predicting a small rate cut in the upcoming monetary policy meeting as credit offtake hasn’t improved and the growth numbers at 5% still remain a concern.

“With this fiscal boost focused on investment revival and not consumption (hence not inflationary), we reckon that the RBI MPC might proceed with a modest cut at the October MPC,” Singapore-based DBS bank’s economist Radhika Rao wrote on Monday.

While most are expecting a rate cut, the central bank is known to spring surprises. The monetary policy committee has to make a majority decision on the direction of the interest rates and while there are little chances, rates will be hiked, the RBI might just go with keeping the rates as is and introduce other measures for boosting credit availability.

What should the government do next?

While the government has managed to boost market sentiments with its tax bonanza, experts suggest that it needs to continue on its reform path if the growth has to be brought back. Economists are hankering for land and labour reforms while the industry is also pushing for GST reforms to make filing simpler and easier. At the same time, fiscal deficit is expected to be hit by 70 basis points, which means that the government will have to find new ways of raising money, especially in the light of the Finance Minister Nirmala Sitharaman’s recent assertion that government spending will not be reined in.

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