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.

The bulls are all securely tied in the pen. The bears are rampaging world markets, not least of all India, hacking ferociously at any attempt by markets to come up from the abyss. Pertinently then, how does one make money in such a volatile market? Every technical support level is being trashed by plunging indices; not an encouraging sign to the potential investor.

Even in such a volatile climate, asset management companies seem to come out with mutual funds that promise the earth, the sky, and everything else in between in a neatly-packed picnic basket. Most of them concentrate on a single sector, the brave few trying the diversified portfolio route.

Though in the long run most equity funds would be a good avenue to invest through, what will happen if volatile conditions remain as the US market moves towards one of its biggest recessions? What should an investor do to still get decent profits?

The one commodity that will retain its luster long-term is gold – that sweet, soft, yellow piece of…well, gold. Although not as significantly and rapidly as the equity markets, gold could be significantly stable throughout the tenure of turbulence.

One domestic firm has recently launched a gold fund that invests in gold equity as well as equity in gold-mining firms. In reality, the fund invests into a gold fund by a parent company in the United States, as in India gold is only traded as a commodity straight up. And there are no gold companies or gold-mining companies listed on our stock exchanges.

A few financial service houses in India have advised their clients not to invest in such avenues fearing that the returns delivered would not be significant. Are their doubts justified?

There is a 35% tax on investments in foreign equity that makes up more than 65% of a fund portfolio. In spite of this, and a 7.5% inflation rate, the gold fund mentioned above gave an absolute return rate of 41.6% - higher than most equity funds – since its inception. This is higher than what most equity oriented funds have achieved in the volatile conditions of the Indian stock markets and even worse conditions of the US stock markets.

The yellow metal will only become dearer as time goes on. Demand will always outstrip supply by a large margin.

A gold-oriented investment in a portfolio would not only buffer the investor’s losses in case of a sudden down swing of the markets, it would also ensure that the investor makes a good amount of profits from his/her investments even if the investment horizon is only up to a year.

Finally, like any good MF, …“Mutual fund investments are subject to market risks, please read offer documents carefully before investing.”

The author is a Relationship Manager working with the Mumbai-based SRE Financial Planners.