Demystifying Rates

What has the RBI done?

On Saturday, November 1 2008 the RBI cut CRR by 100 basis points (50 bps effective October 25 and 50 bps effective November,to 5.5%. Further the repo rate was reduced by 50 bps to 7.5%.
It also cut banks’ statutory liquidity ratio (SLR) by 1 percentage point to 24 percent of their deposits.

What are repo/reverse repo rates, CRR rate and SLR?

Repo and reverse repo rates are the tools of liquidity management. The RBI uses these measures either to inject liquidity into the system when the liquidity conditions in the markets are tight or suck out liquidity, when there is excess liquidity in the system.

Why does the RBI do this?

Excess liquidity in the system stokes up inflation. Higher inflation leads to higher prices, which in turn leads to lower demand adversely affecting the overall economic growth. In times like these, to control inflation, RBI sucks out liquidity from the market, thus reducing the money supply. Similarly, tighter liquidity means banks have less money with them to lend, which forces them to raise interest rates. Raising rates leads to consumers postponing their purchases; businesses deferring their expansion plans, thus reducing the aggregate demand, adversely affecting the economic growth.

Thus it is the RBI’s prerogative to manage inflation without compromising on growth.

How does the RBI do this?

Simply defined the repo rate is the rate at which RBI buys securities from the banks and lends them money. When the liquidity in the markets is tight, the RBI reduces the rate at which it lends to the banks to incentivize banks to borrow more money from them. Thus banks have more money with them to lend to consumers and businesses giving an impetus to economic growth. Also changes in repo rates have a direct bearing on other interest rates like your bank FD rates, home loan rates and so on.

Cash Reserve Ratio (CRR): Banks are mandated to keep certain percentage of their deposits with RBI. This is the CRR. Thus, an increase in the CRR leads to banks parking more money with RBI reducing the funds available with banks. On the other hand a reduction in the CRR keeps more money with banks boosting liquidity in the markets.

To put it simply the repo rate is a rate management tool, whereas the CRR is a liquidity management tool of the RBI.

SLR: It is the amount that a bank has to maintain in the form of cash, gold or approved securities. The quantum is specified as some percentage of a bank’s total demand and time liabilities i.e., the liabilities that are payable on demand anytime, and those liabilities that are accruing in one month’s time due to maturity. This ratio is fixed by the RBI.

What is the current scenario?

In line with its global peers, the RBI also was forced to reverse its tight monetary policy that was being followed to control inflation, to solve the problems arising due to shortfall of funds. Domestic events like advance tax payments, regulatory intervention by the RBI in forex markets to stabilize the depreciating rupee, (aggravated by merciless selling by FIIs in Indian equities) created a huge liquidity crunch in the markets. The liquidity shortage drove up the overnight call rates (rate at which banks give money to each other for short term needs) shooting up to over 20% levels. Banks raised their benchmark prime lending rate (PLR) and were reluctant to disburse,loans,against the sanctioned limits owing to the liquidity crunch. To cool off this liquidity crunch, the RBI in its credit policy on October 24 announced a 250 bps cut in CRR and 100 bps cut in repo rate. The cuts effectively added around Rs 1,30,000 crore to the system. When even this was not enough to tackle the ongoing liquidity crunch, the RBI further announced a slew of rate cuts on Saturday.

It cut CRR by 100 basis points (50 bps effective October 25 and 50 bps effective November,to 5.5%). Further the repo rate was reduced by 50 bps to 7.5%.

It cut SLR by 1 percentage point to 24 percent of their deposits.
If one considers the macro data points, the conditions for easing monetary policy appear favorable owing to:
Inflation showing signs of peaking out
Oil prices continuing their southward journey
Slowing economic growth
The one percentage point cut in CRR is set to release additional liquidity of Rs 40,000 crore into the system.
The SLR cut would inject about Rs 40,000 crore into the banking system.

The RBI now expects banks to pass on the benefit of rate cuts to final consumers in the form of lower interest rates on housing loans and personal loans to boost consumption and revive the slowing economy. Some of the banks have already reacted positively by proactively cutting the benchmark PLR.

Impact on equity markets:The RBI move was a welcome trigger for the stock market, albeit a short-term one, as we saw the markets rallying from the lows of 7700 to 10600. As expected, banking stocks contributed the lion’s share to the rally on the expectation that lower rates will boost consumption demand positively affecting the margins of the banking sector. Also, a cut in CRR (on which banks don’t get any interest) and SLR would enable banks to earn higher margin on released funds.

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