A look at some key terms before the RBI announcement tomorrow

by Shiv Kukreja on July 31, 2012

in Economy

This post is written by Shiv Kukreja

RBI is in a dilemma again. On the one hand, inflation is not coming under control, rise in the prices of vegetables, cereals, milk and oil have been making headlines in newspapers for the last many months, on the other hand, India’s economic growth is slowing down at a faster pace than most experts expected.

In fact nobody expected India’s GDP growth rate to fall so dramatically. Many research houses and brokerages have already cut their FY 2012-13 forecasts for India’s GDP growth. Last time, the consensus was that RBI should cut rates, and this time, largely the consensus seems to be that RBI won’t cut any rates.

As a common man many of us wonder what all these measures are and how these measure actually make an impact in an inflationary environment and also on the growth of an economy. Here is my effort to make you understand this jargon and its impact.

 

Cash Reserve Ratio (CRR): Scheduled Commercial Banks (SCBs or simply banks) in India are required to maintain an average cash balance with RBI, as a proportion of their total deposits. E.g; If CRR is 5%, Banks are required to deposit the first Rs. 5 with the RBI out of their total deposits of Rs. 100 and then use the remaining Rs. 95 for their investment and lending purposes. Banks are mandated to deposit this amount with RBI on a fortnightly basis. CRR is 4.75% at present.

 

Purpose and Impact: Say, if your after-tax monthly income is Rs. 100K and you are required to keep Rs. 5K out of it with your father, then your remaining disposable income is Rs. 95K. RBI plays the role of a father here. CRR is a tool used by the RBI to control the liquidity in the system. So when there is excess money floating around, RBI will raise the CRR to suck out the excess money. On the other hand, if there is a credit crunch, RBI cuts the CRR to release money into the system.

Statutory Liquidity ratio (SLR)

It is the proportion of deposits that SCBs are required to maintain in cash or gold or government approved securities. After keeping the required amount for CRR and SLR, the banks are free to use the remaining deposits for their lending purposes.

Purpose & Impact: SLR, more or less, plays a similar role as does CRR. SLR is determined and maintained by the RBI in order to restrict the expansion of bank credit and like CRR.

Repo Rate (or Repurchase Rate)

This is the rate at which SCBs borrow money from the RBI for a short period of time by selling their securities or financial assets to the RBI with an agreement to repurchase it at a future date at a predetermined price. Repo rate is 8% at present. From banks’ point of view, Repo arrangement with the RBI is like a common man taking a short term loan from a bank.

Purpose & Impact: Higher Repo Rate keeps the demand for funds by the banks in check. Repo rate is the single biggest factor that makes banks raise or lower lending rates on their home loans, car loans etc. You must have read in the newspapers that banks start raising their interest rates within a few days after the RBI raises the Repo rate. Banks do that as their own cost of money rises because of RBI’s actions. They need to maintain their margins in order to keep their profitability intact and show growth to their shareholders.

RBI purposefully raises Repo rate when it wants to discourage Banks to borrow from it and do further lending. This action reduces money flow in the system. RBI raised the Repo Rate by 3.25% (from 4.75% in March 2010 to 8% in December 2011) which made the banks borrow funds at a much higher rate and in turn hiked their lending rates also. An increase in interest rates also makes it more expensive for firms to finance investment. As a result, higher interest rates normally curtail investment. If consumption and investment fall, so does aggregate demand. Lower aggregate demand results in lower resource utilisation. When resource utilisation is low, prices and wages usually rise at a more modest rate.

Reverse Repo Rate

This is the rate at which SCBs deposit their excess money with the RBI for a short period of time. As the name suggests, it is the reverse of a repo (repurchase) agreement. Reverse Repo rate is 7% at present. From banks’ point of view, Reverse Repo arrangement with the RBI is like a common man making a short term deposit with a bank.

Purpose & Impact: RBI raises Reverse Repo rate when it wants to reduce liquidity out of the banking system. Banks would get a higher return on their money parked with the RBI. It also makes banks to offer higher rate of interest on the deposits made by the general public.

Liquidity Adjustment Facility (LAF)

This is a facility extended by the RBI under which banks can borrow money from the RBI by pledging their holding of government securities. Basically LAF enables liquidity management on a day to day basis.

Purpose & Impact: LAF is an important tool of monetary policy and enables RBI to transmit interest rate signals to the market.

 

Overall Impact of RBI measures:

1) Due to Change in Interest Rates: Overall interest rate environment affects the demand for goods and services. Higher interest rates make it more attractive to save and lead to a reduction in household consumption. It also makes it more expensive for firms to finance investment. If both consumption and investment fall, it leads to a fall in aggregate demand and resource utilization. It results in prices and wages rise at a more modest rate.

2) On Inflation Expectations: Due to reasons mentioned above like lower household consumption and lower corporate investments, a tighter monetary policy should result in lower inflation as it reduces the aggregate demand

3) On Exchange Rates: Normally, an increase in the interest rates should result in a strengthening of the Indian rupee. This is because higher interest rates make Indian assets more attractive from a foreign investor’s point of view. The result is a capital inflow and increased demand for rupee, which strengthens the exchange rate.

The consensus this time is that the near drought condition has made RBI’s situation trickier than before and they are between a rock and a hard place. The policy announcement tomorrow will be interesting, and if they make any rate changes that will be even more interesting and even a little surprising.

{ 12 comments… read them below or add one }

Shiv Kukreja July 31, 2012 at 11:34 am

RBI Monetary Policy Update: RBI leaves Repo and Reverse Repo rates unchanged at 8% and 7% respectively, to keep inflation under check; cuts SLR by 1% from 24% to 23% in order to ease liquidity. GDP growth forecast has been lowered to 6.5% from 7.3% earlier and inflation forecast has been raised to 7% from 6.5% earlier.

Reply

ankurm83 July 31, 2012 at 2:25 pm

The fall in SLR, should reduce prices of Govt bonds as banks sell their excess Govt bond holdings. This will inturn increase yields of Govt bonds, doesnt seem to be good

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Shiv Kukreja July 31, 2012 at 4:36 pm

Hi Ankur… I think SLR plays a very small role in making banks to sell their Govt. bond holdings. In fact when banks were required to maintain only 24% SLR, the actual figures were close to 30.12%. Only a few aggressive private banks kept it close to 24% and probably they are going to sell their holdings now.

Govt bond yields rose today as market participants got many hints from the RBI that it is not in a hurry to reduce the interest rates. As mentioned above, RBI lowered GDP growth forecast to 6.5% from 7.3% earlier and raised inflation forecast to 7% from 6.5% earlier. RBI also reiterated that the real interest rates are lower than they were during the “Pre-Crisis Period” (before 2008-09 recessionary economic situation).

All this will put more pressure on fiscal deficit and if our govt remains in a state of policy paralysis for the next 30-90 days, then only God can save us from getting derated and make big investors invest their money in some other emerging economies.

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ankurm July 31, 2012 at 5:28 pm

Hi Shiv, if SLR doesnt play a role, and bank’s actual SLR ratio is already 3-4% excess. then it makes RBI’s move meaningless? Why they have done it at all?

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Shiv Kukreja July 31, 2012 at 7:49 pm

No, I’m not saying it doesnt play any role at all but it is not that significant. Banks which are not able to meet their lending targets or their overall credit requirement is low, tend to park their excess deposits in Govt. bonds and hence their SLR remains high.

RBI move is not meaningless as it creates liquidity for those banks which have credit demand coming to them and want to make use of the funds for lending rather than investing in Govt. bonds.

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ankurm July 31, 2012 at 7:57 pm

Ok. shiv, it makes sense for those banks in need of liquidity. But whats your sense, when do you think rate cuts will begin?

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Shiv Kukreja July 31, 2012 at 8:52 pm

🙂 this is a million dollar question Ankur !!! But I’ll definitely share my opinion.

I track RBI statements closely and when they had reduced policy rates in April by 0.50%, they mentioned it to be a frontloaded cut. I think RBI was not ready to do this big a cut but Govt. forced it to do it with a promise that they’ll take policy actions to check fiscal imbalances along with other supply-side initiatives, critical for inflation management. But till date no action has been taken.

I think most of our genuine problems are because of govt’s inability to take bold decisions and inaction on many important matters. I think rate cuts will begin once inflation comes under control and RBI gets convinced with at least one of the two things – Govt becoming serious about fiscal consolidation or interest rates start hitting the economic growth quite badly, which I think is not the case right now.

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ankurm July 31, 2012 at 9:53 pm

hi shiv, your last line “atleast one of two things”, the second thing (i.e interest rates start hitting growth badly) has been happening since last 1 year. isnt it? I think RBI says “we did what could in April, but Govt did not do anything (to address systemic issues to control inflation etc etc)”, so they have paused. An idea came to my mind, can we do depict movement of interest rate hikes and cuts (along with GDP growth & inflation) over previous few cycles to see, what trends we can conclude on timing of RBI actions?

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Shiv Kukreja July 31, 2012 at 11:59 pm

Answering your first question – Probably yes, high interest rates are hitting growth, but the impact has been marginal not that bad. There are many sectors which are suffering due to reasons other than high interest rates. Power sector’s problem is coal shortage & govt’s inability to resolve critical issues, telecom & other infrastructure sectors’ are struggling due to policy paralysis & scams, airlines industry is bleeding due to inefficient managements.

At a time when some major economies are struggling to avoid recessionary conditions, there are several means to have cheap financing. A few days back, SBI raised $1.25 billion issuing 5-year bonds at the cheapest ever effective rate of 4.125%. The issue got oversubscribed by 5.2 times. So, I would say it is good to have low interest rates but it is better if our politicians use our hard earned money (taxes we pay) for the develpoment of our nation.

Also, RBI policy measures always have their impact with a lag. Unfortunately, this time these measures have failed to make their impact on inflation. We, as consumers, are not bothered with what is happening around us. We’ve continued our spendings unabated on big cars, luxury items, LCDs, mobiles, laptops, malls, holidays, gyms etc. etc. We dont think twice before spending Rs. 2000 on a weekend movie and another Rs. 5000 on a lavish dinner. Hence, though RBI wants to ease liquidity somewhat for the industrial growth, inflation nos. are not supportive.

If you come up with any interesting observation during your research, please do share it with me.

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Neeraj August 2, 2012 at 9:27 pm

Very Nicely explained . Thanks for the nice post .

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Shiv Kukreja August 3, 2012 at 9:50 am

Thanks Neeraj for your encouraging words! 🙂

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Abhijit February 1, 2013 at 11:55 am

Good one.!

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