Front-loaded gateway to bridge the output gap of the economy

Time of India

9 hours ago

Dr Rao is currently teaching risk management in the institute of Insurance and Risk Management (IIRM). A career banker with Bank of Baroda, he held the position of General Manager - Strategic Planning, Later was Associate Professor with National Institute of Bank Management (NIBM) and was Director, National Institute of Banking Studies and Corporate Management (NIBSCOM). He writes for financial dailies on Banking and Finance and his work can be viewed in the public domain.His academic accomplishments include Ph.d in commerce from Banaras Hindu University (BHU), MBA ( Finance), LLB. He runs a Youtube channel - Bank on Me - Knowledge series He likes to share his perspectives with next generation potential leaders of the banking industry. His book on "Transformation of Public Sector Banks in India' was published in september 2019. His most interesting work is in Ideasforindia.com blog. LESS ... MORE
Analysis of reasons for front-loading the repo cut by 50 basis points
reflects the strategic move of the RBI to pave the way to close the output gap and harness full potential growth. The entire reinforcing measures of the monetary policy are intended to activate the adrenaline of the various sectors of the economy to ensure that the growth reaches an aspirational trajectory of 8 percent.
The proactive measures signal that there may not be further rate cuts in the next policy review in August 2025. During FY26, there could be further softening of interest rates if inflation continues to be benign and the growth rate remains below its potential. The data will be closely monitored to read the pulse of the economy to align monetary policy tools.
The present repo rate cut will lower the borrowing costs of enterprises and retail borrowers, which should lead to capacity expansion, diversification, and a revival of private investments. The EMIs of existing retail borrowers linked to repo rates will come down. The multiplier impact could spur consumption demand to plough back into speedier GDP growth.
The CRR has been reduced by 100 basis points from 4 percent to 3
percent, providing structural liquidity support of up to Rs. 2.5 trillion on the NDTL outstanding now. The reduction in CRR will benefit the banks in better managing liquidity risks as they embark on navigating a low interest rate regime.
Looking to the limited scope of easing policy, the stance of the policy has been changed from 'Accommodative' to 'Neutral'. Having brought liquidity to a surplus state, enough time is provided to regulated entities as the LCR reforms are made effective from April 1, 2026. Given the latitude of CRR cut and gross domestic savings (GDS) looking up, it will be up to banks to work out their business strategies to compete for resources to create additional lendable funds. The RBI announced to halt daily VRR auctions from June 11 as system liquidity reaches a surplus of Rs. 2.75 trillion.
1. State of the economy:
The economy is resilient but is below its potential, with GDP for FY25 ending at 6.5 percent and GVA reaching 6.4 percent, supported by the revival of Q4 GDP to 7.4 percent. RBI asserted that the domestic economy exhibits strength, stability, and opportunity that the stakeholders can unleash. Strength comes from 5 key sectors– Corporates, banks, households, government, and the external sector, with their stronger balance sheets. Stability flows from three fronts – price, financial, and political. Opportunities for investors stem from 3Ds – demography, digitalisation, and domestic demand. RBI succinctly puts the potential of the economy in a frame of 5x3x3 metrics.
Thus, the Indian economy is capable of withstanding the external sector risks. Notably, the outlook of global growth has been tapered by the IMF to 2.8 percent for 2025 and 3 percent for 2026, well below the historical average of 3.7 percent recorded between 2000 and 2019. The geopolitical risks and tariff tussle continue to exacerbate the risks of external sector uncertainty.
2. Output gap:
One of the underlying reasons for proactive front-loading of measures is to harness the full potential of the growth latent in the economy. All support measures are organised to ensure that the various sectors of the economy are fully galvanised to pump prime growth. The output gap measures the difference between an economy's actual output (real GDP) and its potential output— the maximum sustainable output achievable when all resources (labour, capital, etc.) are fully and efficiently utilized.
In the given complexity of output gap measurement, it is difficult to
assess the output gap precisely, in a Reuters poll ahead of the June 6
MPC meeting, economists noted that the risk of overheating of the
economy remains low with persistence of a negative output gap as
indicated by persistently low core inflation and low current account
deficit.
In the 2023 Article IV Consultation (staff report published late 2023), the IMF stated that India's output gap was 'broadly closed'. It means the actual GDP is very close to potential GDP. No precise percentage was provided, but the designation 'broadly closed' typically indicates an output gap near zero (±0.5 percent of GDP).
Negative Output Gap can occur when actual output is below potential output, indicating underutilized resources. This often leads to higher unemployment and downward pressure on inflation. Positive Output Gap is possible when actual output exceeds potential output, suggesting the economy is operating beyond its sustainable capacity. This can result in inflationary pressures due to increased demand.
It can be inferred from the policy measures now put in place that a
negative output gap is hurting the economy, preventing it from growing to its full potential. Some reinforcing policy support, both fiscal and monetary, is needed to bridge the output gap. All possible support measures have been put together in the current edition of the monetary policy, and the transfer of surplus of Rs. 2.69 trillion in the current year to the exchequer should be able to plough back as fiscal support.
It can be recollected that the RBI's April 2025 Monetary Policy Report highlighted that while growth has slowed compared to FY24, the economy is still below potential. Though the report didn't attach a specific percentage to the output gap, it stressed that the growth still falls short of the country's potential and maintained an 'accommodative' stance. Now it is shifted back to 'neutral'.
3. Credit growth:
The bottom of the economic pyramid depends on bank credit to
undertake economic activities. It is estimated that nearly 60 percent of non-corporate borrowers heavily depend on banks and NBFCs for
institutional credit. CRISIL reports that the corporate sector accounts for roughly 41 percent of total bank lending in India for FY 2025. Within this, lending to NBFCs—a sub-segment of corporate credit—makes up about 18 percent of the corporate share. So, the corporate sector gets close to 25 percent of the credit flow. They have alternative sources to tap, but middle and low-end borrowers forming part of a large segment of entrepreneurs depend heavily on formal financial intermediaries.
In the given circumstances, unless bank credit to MSME, retail, and farm sectors grows and, more importantly, to the low ticket borrowers, the economy cannot bridge the output gap, if any. Though ease of doing business and policy support are extended to enable faster flow of credit to non-corporate borrowers, in reality, it has yet to realize its full potential. Banks must strategise their ways to augment lendable resources to fully tap the potential growth to help the economy reach the aspirational growth trajectory.
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Views expressed above are the author's own.