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 incentivise 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:

1. Inflation showing signs of peaking out
2. Oil prices continuing their southward journey
3. 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.

Kapil Mokashi is an Associate Financial Planner, working with Sharekhan Ltd. as an equity advisor.

Personal loans are gaining popularity among loan seekers in a big way. Be it planning a vacation or getting you daughter married, down payment of your new house or medical obligations, a personal loan may be used for any purpose. A personal loan may be a secured or an unsecured loan where the end use of the money is not supposed to be declared while taking the loan. The rate for unsecured personal loans ranges from about 15 % to 25 % per annum depending up on the credit history and the income of the loan seeker. This type of personal loan is more popular among the public.

The problem begins when people take these kinds of loans for investments into various instruments including equities. Markets have been pretty volatile for last few months and are expected to behave the same for quite some time. So if you planning to take a personal loan and invest in to equities of mutual funds thinking that the markets are at low then think again. The inflation rate has been moving up. The last numbers posted was well above 12%. With the growth in the Gross Domestic Product (GDP) around 8% to 9% the economy may see a negative growth in the current fiscal. The Reserve Bank of India has tried to tighten the liquidity situation by increasing the Cash Reserve Ratio (CRR) by 50 basis points. They may increase it by another 50 to 100 basis points if needed to keep a check on the inflation numbers. The condition worsens if the loan you have taken is on a floating interest rate. You end up losing money in the equity markets and pay more towards the loan at the same time. This is like being the rope in a tug of-war match where both sides are trying to pull you towards themselves to the fullest.

A better way to invest into equity market is by the way of arbitrage. It is buying in the cash market using the loan amount taken and selling it in derivative market by way of futures at a price which is more than the price bought added with the interest amount. On the day of maturity you reverse your position on both the markets and difference of the amount over and above the cash market price added with interest on the loan and the price sold in the futures market is your profit.

To explain arbitrage lets take the following example.

One lot of Reliance Industries Limited (RIL) is of 75 shares. Suppose the price of one RIL share is Rs. 2200 on 1st July, 2008. The maturity is on 31st July, 2008. The total amount of loan of 75 shares is (2200*75) = Rs. 165000. If the interest rate is 18% per annum then for one month the amount of interest is (165000*1.5%) = Rs. 2475 which is (2475/75) = Rs. 33 per share. Thus you need to short one lot of Reliance at any price which is more than (2200+33) = Rs. 2233. If you manage to short at a price say Rs. 2250, then you make a profit of (17*75) = Rs. 1275 on one lot which is almost 9.3% per annum. Now no matter what the price is on the expiry, you will manage to earn the amount stated above as you have already squared off your position.

The main thing over here is to find the right price to buy in the cash market and sell in the futures market. If you manage to hit the right price over the screen, then bingo! You have made money where everyone is losing it.

In India, as per regulation, every bank must park a certain amount with the Reserve Bank of India (RBI). This amount is a certain percentage of the total customer deposits held by the bank. This ratio of the cash held at the bank to the reserve at the RBI is called the Cash Reserve Ratio (CRR).

The RBI pays a certain amount of interest to the bank on these reserves.

The ratio is used as an effective tool in monetary policies of the country, regulating the money supply in the economy and thereby curbing inflation. It also helps in meeting the banks’ withdrawal demands.

For instance, if the CRR is 10%, a bank with deposits to the tune of Rs. 1 crore has to deposit Rs. 10 lakh at the RBI.

Inflation is the rate of increase in prices. Simple.

In times of low inflation people grumble that prices still go up. They will, but at a low rate. Deflation is prices going down!

We have recently seen prices galloping. This has rightly been blamed on crude petroleum oil prices that have been accelerating, seemingly without the hint of a brake.

How is oil the spoke in our own wheel? Why does it cost so much more to fill the kitchen shelves? Oil. Crude oil provides petrol and diesel - fuel for our transport. A hike in its price makes it costlier to produce the fertilizer (an oil product), run the tractor, pump the water (a lot of electricity is also produced from oil products) and bring it to your neighbourhood mandi.

Some inflation is a good thing. Just like a bit of temperature is good for the body (98.6˚F is normal temperature), a bit of inflation makes the economy grow, justifying salary increases and interest on our deposits!

Inflation is dangerous when it is out of control. This can happen when plenty of money is printed. Foreign money entering our economy produces local money; the Government running deficit budgets also creates money supply. When a lot of excess money tries to buy the normal production of goods and services prices go up – INFLATION!! Your salary increases and bonuses also cause inflation, as also the higher interest you get on your deposit. Inflation is a dragon eating up the value of your money, as you need more money to buy the same product.

In the interest of the ecology and driven by higher petro prices, a lot of sugarcane and corn produced is being used to produce ethanol (ethanol is being used as a substitute for oil in cars, trucks), instead of being directly consumed. With agricultural land being limited, there has been a decrease in food production, taking food prices up. We have a new term for this, Agflation.

The Reserve Bank of India (RBI) has been increasing interest rates and reducing the money in the economy to curtail inflation. Will it work, and if it will, how?

Less money available will buy less. Higher interest rates will reduce the feasibility of borrowing to consume – most homes and a lot of vehicles are bought on credit. This will surely impact inflation. But is it enough? What is the cost of the rate hikes?

I believe it was in the year 2000 that our then RBI Governor, Mr. Bimal Jalan, said that the Central Governments of the world do not react to supply side inflation. In the current situation of the RBI’s monetary tightening, would the price of oil drop in response to the Indian rate hikes? Not likely, is my bet.

What then, could this tightening do? For one, this will hurt banks. As money becomes scarce, they need to raise deposit rates. They will also have to maintain a higher Cash Reserve Ratio (CRR, now at 8.75% of their deposits), earning no interest on amounts above 3.5% (and getting only 3.5% interest on that portion). At higher interest more loans will default, ouch! Projects being set up become costlier at higher interest rates. Ongoing housing projects may get delayed as rising interest costs will impact the borrowing of builders. There will be less industrial investment, which will hurt us with lower production in the years to come, meaning a lower GDP, less jobs and a lot more pain. This could just be a return to the old Indian “Hindu rate of growth”, or worse, recession. Oil for the moment, is likely to remain expensive, leading to ‘Stagflation’, which is prices rising in a stagnant economy.

Do you say a prayer, or are we left without a hope or prayer?

Naveen Fernandes is a Certified Financial Planner and Vice-president, Orbis Financial Corporation Ltd, Mumbai. Orbis Financial is a SEBI-approved custodian.