THE CONTEXT: In February 2025, the Reserve Bank of India (RBI) reduced the repo rate by 25 basis points (bps) to 6.25%, marking its first rate cut in five years. This decision aligns with global accommodative trends and stimulates growth amid moderating inflation.
KEY TERMINOLOGIES
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- Repo Rate: The rate at which the RBI lends short-term funds to commercial banks against government securities. It is a primary tool for liquidity management and inflation control. A cut lowers borrowing costs, while a hike curbs excess money supply.
- Reverse Repo Rate: The rate at which the RBI borrows from banks to absorb surplus liquidity. It acts as a floor for short-term interest rates.
- MCLR (Marginal Cost of Funds-Based Lending Rate): The minimum rate below which banks cannot lend, determined by their marginal cost of funds, operating expenses, and tenure premium.
- Transmission Lag: Past repo rate hikes (250 bps since 2022) saw only 175 bps transmission to MCLR.
- EBLR (External Benchmark-Linked Lending Rate): Loans directly linked to external benchmarks like the repo rate, ensuring faster transmission of RBI rate changes.
RATIONALE BEHIND THE RATE CUT:
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- Slowing Credit Growth: Industrial credit growth decelerated to 9% YoY in September 2024, indicating a potential slowdown in private sector investment. This trend aligns with the broader economic deceleration, necessitating monetary policy intervention to revive credit offtake.
- GDP Concerns: FY25 GDP growth is projected at 6.4%, a significant drop from 8.2% in FY24. The RBI’s growth forecast for FY26 stands at 6.7%, reflecting cautious optimism about the rate cut’s stimulative effect.
- Headline Inflation Moderation: Inflation eased to 5.2% in December 2024, moving closer to the RBI’s target range of 4±2%. The central bank projects retail inflation at 4.2% for FY26, indicating confidence in price stability.
- Core Inflation Dynamics: Core inflation has dipped below 4%, providing the RBI with policy space for monetary easing. This trend suggests that underlying inflationary pressures are contained, allowing for a growth-supportive stance.
- Synchronized Monetary Easing: The rate cut aligns with the accommodative stance adopted by major central banks globally, including the Federal Reserve and European Central Bank. This synchronization aims to counter geopolitical risks and trade tensions, exemplified by recent US tariff announcements in Canada, Mexico, and China.
- Currency Volatility: The Indian rupee touched an all-time low of ₹87 against the USD, posing potential inflationary risks. The rate cut may help manage currency volatility by attracting foreign capital inflows.
POSITIVE IMPACTS:
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- EBLR-linked loans: Immediate 25 bps reduction in EMIs for home loans and other EBLR-linked credit facilities. For instance, a ₹80 lakh home loan for 20 years will see an EMI reduction from ₹71,978 to ₹70,697, with total interest savings of ₹3.07 lakh.
- Transmission efficiency: EBLR ensures faster and more transparent transmission of monetary policy changes compared to the MCLR regime.
- Credit offtake: Lower borrowing costs are expected to stimulate credit demand across sectors, potentially addressing the slowdown in industrial credit growth (9% YoY in September 2024).
- Infrastructure and manufacturing revival: Cheaper credit may catalyze the completion of stalled projects, particularly in capital-intensive sectors4.
- GDP growth projection: RBI estimates FY26 GDP growth at 6.7%, up from 6.4% in FY25, indicating confidence in the rate cut’s stimulative effect.
- Fiscal-monetary synergy: The rate cut complements recent fiscal measures, including personal income tax cuts announced in Budget 2025, potentially creating a multiplier effect on consumption and investment.
RISKS AND CHALLENGES:
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- Global Commodity Price Shocks: Volatility in global crude oil prices, geopolitical tensions, and disruptions in global supply chains could reverse recent gains in inflation control. For instance, crude oil prices rising above $90 per barrel could significantly impact India’s import bill and inflation trajectory. Food inflation remains a concern due to uncertainties in global agricultural commodity markets, mainly wheat and edible oils.
- Monsoon Uncertainty: India’s dependence on monsoons for agricultural output makes inflation vulnerable to erratic rainfall patterns. A deficient monsoon could lead to higher food prices, undermining the RBI’s projected retail inflation of 4.2% for FY26.
- Depreciating Rupee: The Indian rupee recently touched an all-time low of ₹87/USD, increasing the cost of imports for essential commodities like crude oil, fertilizers, and electronics. This could lead to imported inflation, offsetting the benefits of lower domestic borrowing costs.
- Decline in Fixed Deposit Rates: A repo rate cut typically leads to declining fixed deposit (FD) rates banks offer. This could adversely affect retirees and conservative investors who rely on interest income for sustenance. For example, average FD rates have fallen from 7.5% in FY23 to 6.8% in FY24, eroding real returns when adjusted for inflation.
- Dual Lending Systems: The coexistence of MCLR and External Benchmark Linked Lending Rates (EBLR) creates disparities in rate transmission across borrower segments. While EBLR ensures immediate transmission, MCLR-linked loans experience delays due to internal cost structures.
- Crowding Out Effect: The government’s high borrowing program (₹15 lakh crore for FY25) could crowd out private investment by keeping long-term interest rates elevated despite the repo rate cut. Sovereign bond yields remain sticky due to persistent fiscal deficits (estimated at 5.9% of GDP for FY25), limiting the effectiveness of monetary easing.
- Banking Sector Margins: A reduction in lending rates may compress Net Interest Margins (NIMs) for banks in the short term, particularly for public sector banks with higher exposure to fixed-rate loans. Smaller banks with weaker capital buffers may struggle to maintain profitability amid declining interest income.
- Real Estate Sector Risks: While lower EMIs are expected to boost housing demand, high input costs for construction materials like steel and cement could offset these benefits, limiting growth in the sector.
- Geopolitical Uncertainty: Ongoing trade tensions between major economies like the US and China could disrupt global trade flows, impacting India’s export-driven sectors. A synchronized monetary easing cycle by central banks globally may lead to excessive capital inflows into emerging markets like India, potentially destabilizing exchange rates.
- US Federal Reserve Policy Divergence: Any unexpected tightening by the US Federal Reserve could lead to capital outflows from India, putting further pressure on the rupee and foreign exchange reserves.
THE WAY FORWARD:
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- Enhancing Monetary Policy Transmission: Mandate wider adoption of the External Benchmark Lending Rate (EBLR) system for all retail loans, not just home loans. Implement a transparent mechanism to ensure banks pass on rate cuts to borrowers within a specified timeframe. Introduce incentives for banks that achieve complete transmission, such as preferential access to liquidity windows.
- Balancing Growth and Inflation Management: Implement a flexible inflation targeting framework for temporary deviations from the 4±2% target during supply shocks. Develop sector-specific credit policies to channel funds to productive sectors while managing overall liquidity. Collaborate with the government to address supply-side constraints in agriculture and essential commodities to mitigate food inflation risks.
- Strengthening Financial Inclusion and Savings: Introduce special savings schemes for senior citizens with higher interest rates, similar to the Senior Citizen Savings Scheme but with more flexible terms. Promote financial literacy programs targeting rural and semi-urban areas to encourage formal savings. Develop innovative financial products that balance returns and liquidity for risk-averse investors.
- Enhancing Credit Flow to MSMEs: Expand the scope of the TReDS (Trade Receivables Discounting System) platform to include more PSUs and large corporates. Implement a credit guarantee scheme for first-time MSME borrowers to encourage banks to lend to this sector. Introduce a differential risk-weighting system for MSME loans based on the enterprise’s sustainability and innovation potential.
- Managing External Sector Risks: Implement a more active forex intervention strategy to reduce volatility without targeting a specific exchange rate. Encourage Indian companies to hedge their foreign currency exposure through market-based instruments. Develop rupee-denominated bond markets to reduce dependence on foreign currency borrowing.
- Aligning Monetary and Fiscal Policies: Establish a formal mechanism for regular consultation between the RBI and the Finance Ministry on policy alignment. Implement a medium-term debt management strategy to reduce the crowding-out effect of government borrowing. Develop a comprehensive financial stability framework integrating monetary, fiscal, and macroprudential policies.
THE CONCLUSION:
The RBI’s repo rate cut reflects a balanced approach to growth and price stability. Its success depends on efficient transmission and fiscal-monetary coordination. Structural reforms are essential for inclusive and sustainable economic development while ensuring financial stability.
UPSC PAST YEAR QUESTION:
Q. What are the causes of persistently high food inflation in India? Comment on the effectiveness of the monetary policy of the RBI to control this type of inflation. 2024
MAINS PRACTICE QUESTION:
Q. Monetary policy in India operates within a complex web of growth imperatives, inflationary pressures, and external vulnerabilities. Critically examine the effectiveness of the Reserve Bank of India’s (RBI) monetary policy decisions in navigating these challenges.
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