On December 5th, the Monetary Policy Committee (MPC) implemented a 0.25% reduction in the repo rate, bringing it down to 5.25%, a decrease from 6.50% before February. This decision reflects recognition of robust GDP growth and a significant decline in inflation. The Reserve Bank also adjusted its inflation forecast downward from 2.6% to 2.0%, while simultaneously raising its GDP forecast from 6.8% to 7.3%. These indicators suggest that India is emerging as a model of sustained high growth coupled with low inflation, and that the economy is demonstrating continued strengthening. With inflation moderating, further development is anticipated in the forthcoming months.
Typically, significant GDP growth does not coincide with repo rate reductions; however, the current context, despite a reported GDP growth rate of 8.2% during the second quarter of the fiscal year, necessitated this decision. The government has set a target to limit the current account deficit to 10% of nominal GDP, which requires sustained high growth to mitigate the deficit effectively. Furthermore, with aspirations to achieve developed nation status by 2047, the centenary of independence, the nation needs a GDP growth rate between 7.5% and 8.0% in the ensuing years. Thus, it is crucial to accelerate economic activity, increase public spending, and stimulate domestic investment.
The recent repo rate reduction marks the first adjustment since June. Since February, the Reserve Bank has decreased the repo rate by a cumulative 1.25% across four successive reductions; however, borrowers have benefited by only approximately half of this reduction. Before the December 5th cut, the overall reduction was 1%, but lending rates have only been lowered by 0.58% due to a pronounced capital shortage.
Currently, banks are offering higher interest rates on deposits, limiting their ability to pass on the full benefits of the repo rate cut. This balancing act is necessary to maintain favourable spreads between deposit and lending rates, thereby safeguarding profit margins. Consequently, banks have reduced deposit rates by 1.06% between February and October, leading to a decline in public interest in term deposits and prompting a shift toward investments in debt and money market instruments, as well as the bond market.
In addition to the repo rate cut, the Reserve Bank has opted to inject an additional ₹1.45 lakh crore into the banking system. This infusion comprises the purchase of ₹1 lakh crore in government bonds in December and the execution of a $5 billion (approximately ₹42,000 crore) three-year dollar/rupee buy-sell swap. This initiative aims to enhance liquidity in the banking system and address the prevailing dollar shortage.
For the fiscal year 2025-26, the Reserve Bank has revised its GDP growth forecast from 6.8% to 7.3%. The projected GDP growth for the third quarter has been increased to 7.0% from 6.4%, and the fourth quarter forecast has been adjusted to 6.5% from 6.2%. Projections for the first quarter of fiscal year 2026-27 suggest a growth rate of 6.7%, up from 6.4%, while the second quarter is anticipated to grow at 6.8%.
Furthermore, the average retail inflation for the current financial year has been forecasted at 2.0%, down from 2.6%. The third-quarter estimate has been revised down to 0.6% from 1.8%, and the fourth-quarter forecast for FY 2025-26 has decreased to 2.9%, previously estimated at 4.0%. Therefore, the decision to lower the repo rate by 0.25% appears to be a justified action by the MPC members amidst a backdrop of high growth and low inflation.
This recent decision by the Reserve Bank is poised to bolster the economy further and maintain inflationary control. Analysts predict that the real estate sector is likely to benefit significantly; lower lending rates are expected to stimulate housing demand, thereby enabling real estate developers to profit by responding effectively to this demand. Additionally, the repo rate cut will benefit other sectors, including micro, small, and medium-sized enterprises (MSMEs), corporates, and agriculture.
Presently, banks are grappling with a deficiency of affordable capital, necessitating Reserve Bank intervention through the provision of low-cost capital. This is particularly crucial, as banks have extensively marketed insurance and mutual fund products in recent years, leading customers to use their bank deposits for these investments instead. Consequently, this shift in investment behaviour has diminished the appeal of bank deposits, leading customers to seek out potentially higher returns in the mutual fund & stock market.
To further stimulate economic growth, it is essential to enhance overall economic activity. This enhancement necessitates the provision of affordable loans to micro, small, and medium enterprises (MSMEs), as well as to the industrial, agricultural, and service sectors. Banks can extend credit only if they have access to low-cost capital. Consequently, in conjunction with the reduction of the repo rate, the Reserve Bank is injecting ₹1.45 lakh crore into the banking system to facilitate this objective.
Satish Singh serves as a Senior Banking and Economic Columnist located in Mumbai. The insights presented in the article reflect his personal viewpoints and analysis.
