JP Morgan for interest rate cut

“A reduction in nominal interest rates will also bring down real rates to more reasonable levels. Lower rates will bring down interest costs for industry, keep stock market sentiment firm, augmentforeign portfolio inflows and help the government meet its disinvestment targets,” it said. The report said a cut in cash reserve ratio (CRR) requirements for banks was needed if there was to be the desired impact. “A CRR cut will make a larger amount of funds available to the corporate sector, improve margins of banks and help them pass on benefits of reduced costs to end borrowers," it said.

JP Morgan said a steep drop in wholesale price inflation had pushed real interest rates to the highest levels seen in the past five years. Year-on-year wholesale price-indexed inflation fell to 2.03 per cent in the week ended June 26 — the lowest since the early 1980s — from 2.53 per cent a week earlier. “Further with a bumper agricultural output last year, a relative absence of adverse demand pull factors and a fairly stable exchange rate, inflation is expected to remain benign in the near term,” JP Morgan said.

“This creates strong arguments in favour of a reduction of nominal interest rates. Also, withindustry showing preliminary signs of recovery, this is an opportune time for the RBI to cut interest rates and fuel the growth process,” it said. The report said the difference between the short-term rates – the bank rate of eight per cent and the repo rate of six per cent – and inflation was at its highest since November 1997. A spread of 800 basis points between the one-year treasury bill yield and inflation also seemed unsustainably high, it said.

A resurgence of foreign investment inflows now that the Kashmir issue was almost resolved would also boost deposit growth with banks and add to liquidity, it said.

The two per cent CRR cut announced in the October 1997 credit policy was never fully implemented as CRR was hiked from 9.50 per cent to 10.50 per cent in January 1998 and again from 10 per cent to 11 per cent in August 1998 — both cases to defend the currency. However, since August 1998 foreign exchange reserves have increased US $ 6 billion, inflation has declined from over 8 per cent to 2.03per cent and market sentiment in general has improved considerably.

These developments have kept the rupee fairly stable over the past ten months even in the face of a collapse of the government and a war. Also, expectations (going by what is priced into forwards) are that currency stability will continue with the Kashmir problem resolved and sentiment distinctly better. In such a scenario it seems unnecessary to keep CRR at a high level of 10.50 per cent.