Will Rate Cuts Improve The Global Economic Scenario?

To breathe life into their flagging economies, a majority of the important global central banks have cut interest rates. In an anticipated move, the European Central Bank (ECB) has cut its key interest rates to a historic low of 0.75 per cent. This move is expected to free up extra cash for spending and investment as many businesses and households will see some reduction in the borrowing costs.

At the same time, the ECB had cut its overnight deposit rate from 0.25 per cent to zero. The deposit rate is the rate on which ECB pays banks to park money with the ECB overnight. This move is expected to encourage banks to invest their money in the real economy or lend to each other. About 800 billion euros (USD 1 trillion) are currently being deposited with the ECB each day. 

With the European debt crisis curbing growth across the globe, the ECB was already under pressure to ease monetary conditions. However, even though the ECB’s key interest rates are now below 1 per cent for the first time in the history of the euro zone, hopes are not high that the rate cut will have much of an effect on the economy. Rather, the analyst fraternity has taken it on a negative basis. The reason is that the rate cut only indicates expected weakness in economy. As per ECB’s president Mario Draghi, the rate cut is unlikely to kick-start new activity. When the demand for loans is weak, the ECB’s rate decisions have a muted effect. Prior to Thursday’s announcement, International Monetary Fund’s head, Christine Lagarde, likewise indicated that she didn’t have high hopes from a rate cut and urged the ECB to resume its program of buying up sovereign bonds from the struggling euro zone countries.

By cutting its rates near to zero the ECB has moved closer to central banks in the U.S., U.K. and Japan, all of which have rates close to zero. These banks have also made greater use of their ability to print money to purchase vast amounts of government bonds and other assets to keep interest rates down and spur growth.

On the other hand, Denmark’s central bank, Nationalbanken, echoed the ECB’s move to cut its key interest rates by slashing its deposit rate below zero for the first time. Nationalbanken left the key policy lending rate in positive territory - although it was cut by 0.25 basis points - from 0.45 per cent to 0.2 per cent. So, it is still charging interest on its loans, but not much.

According to the Danish financial sector organisation Finansraadet, the new negative deposit rate could cost the banks of Denmark between DKK 400 million (USD 68 million) and DKK 500 million in interest expenses. In order to avoid potentially significant losses, the banks could quickly shift liquidity away from Nationalbanken’s deposit facility to other countries or try to increase lending to the corporate sector in the country.

Simultaneously, The People’s Bank of China (PBC) has also reduced its interest rates for the second time in less than a month to allow banks to lend at even lower rates. PBC has surprised many by lowering interest rates by 0.31 per cent to 6 per cent by just one week before China’s second quarter GDP release. Combined with a similar cut in June 2012, the cost of one-year loan in China has fallen by more than two percentage points in the past few weeks. 

Of course this string of rate cuts gives a positive indication about the action of global leaders against the bleak economic outlook. Meanwhile, the current rate cuts may impact little to aid the tumbling economies due to lower credit demand across the globe.  But any further policy measure by global leaders would definitely signal improvement in the fiscal scenario.

On the domestic front, the scenario is not yet clear on whether the RBI will go ahead with rate cuts when they meet on July 31. But with a decline in commodity prices, the possibility of inflation coming down is high. Hence this may give the RBI some room for rate cuts. However, clarity will only come in the next two weeks.