No surprises: on RBI repo rate cut

No surprises: on RBI repo rate cut

Context:

  • 25 basis points cutin benchmark interest rates by the Reserve Bank of India in its first bi-monthly policy statement of the financial year.
  • The Monetary Policy Committee (MPC) decided to hold the change and settle for a conservative approach given the varying sets of data that it was beard with.

Reason for basic points cut:

  • On the one hand, ination, despite the mild spike in February, is well under control at 2.6% and is projected to average 3.2% to 3.4% in the first half of 2019-20.
  • This is below the 4% target set for the MPC.
  • It is one of the vital money control mechanisms used by the central bank of the country.

What is Repo rate of RBI?

  • Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds. Repo rate is used by monetary authorities to control inflation.

What is Repo rate in India?

  • The Reserve Bank of India increased the Repo Rate again on the quater2/Q2 (1st of August 2018) from 6.25% to 6.50%.
  • Even the reverse repo rate was increased to 6.25% from 6%, and the Marginal Standing Facility Rate went up by 25 basis points to 6.75% from 6.50%.

Reverse Repo rate:

  • Reverse Repo rate is the rate at which Reserve Bank of India borrows funds from all the other commercial banks in the country.
  • In other words, it is the rate at which commercial banks in India park their excess money with Reserve Bank of India for a short-term period.
  • Current reverse repo rate is calculated at 6%.

Importance of Repo rate and Reverse repo rate:

  • It deals with the deficiency of funds and liquidity in the market.
  • Bank lending and investment rates are decided based on the repo rate and reverse repo rate.
  • It’s the most effective and efficient tools used by the Reserve Bank of India to achieve price stability and to boost economic development.
  • This is the most crucial monetary policy instruments available to the RBI.
  • There is considerable rise in borrowing by commercial banks through repo route which makes it an important element of India’s monetary policy framework. The constant nature of the balance between Repo and Reverse-Repo makes it more powerful in the Indian banking system.

Significance of Repo rate and Reverse repo rate:

  • Liquidity Regulator:Under the liquidity framework designed by Reserve Bank of India, many facilities are offered to commercial banks to meet their requirement of immediate liquidity or deficiency of funds.
  • The main motive of the liquidity framework is to avoid any liquidity crisis in the Indian banking system. This popular system of liquidity framework is generally known as repo.
  • In the similar way, Reserve Bank of India has a framework for surplus funds/cash in the banking system which ensures there is no excess liquidity in the system. And this framework is referred to as reverse repo.
  • Basically, repo transactions inject liquidity into the Indian banking system. On the other hand, reverse repo absorbs liquidity from the Indian banking system.
  • Price Stability:Reserve Bank of India has to control the rate of inflation and stimulate the economic growth and strike a balance between both inflation and economic growth by revising the repo rate on a half yearly or quarterly basis.
  • It is important for the country’s economic growth. And it’s equally important to avoid the higher rate of inflation in the country.
  • This is where repo rate and reverse repo plays a crucial role by helping Reserve Bank of India strike a balance between both inflation and economic growth.

Effect of Repo rate:

  • Increase in Repo Rate:Lending rates and deposits offered by banks are impacted by a rise or fall of repo rate. However, it may not have an immediate effect.
  • Banks may analyse their liquidity position and cost of funds before increasing the deposit rates and the lending rates.
  • After analysing the cost of funds and liquidity position, banks may begin to pass on their interest rate burden to its end customer in the form of elevated lending rates. That means higher equated monthly instalment for existing borrowers and higher rate of credit for new borrowers.
  • Home loans and other floating rate loans get majorly affected due to rate change. Higher lending rates may lead to a slowdown of the lending business for the banking sector, which will have an impact on their profitability.
  • Post analysis of liquidity position, banks may also hike the rate of bank deposit offered to customers to attract more inflow of funds into the banking system.
  • Reduction in Repo Rate:Banking is the first sector to get affected by any change in monetary policies. It’s a big relief to bank when Reserve Bank of India decides to reduce the repo rate. With the dip in repo rate, banks can borrow from Reserve Bank of India at a cheaper rate.
  • With the accessibility of low cost credit, banks may even reduce the lending rates to its customer after analysing the liquidity condition and the deposit inflows. Banks may offer credit to its end customer at a reduced rate.
  • As bank loans get cheaper, consumers can spend and borrow more while spending a lot less in borrowing. Increased lending business will boost the profitability of the overall banking system.
  • However, lending rate cut and deposit rate hikes are purely dependant on the bank’s liquidity position and deposit demand from customers.

Impact on the Economy

  • Increase in Repo Rate:When Reserve Bank of India hikes repo rates, it becomes costlier for banks to borrow. In other words, banks will have to pay more interest on their short-term borrowings from the Reserve Bank of India.
  • Costlier credit option for banks prompts them to hike the lending rate which they offer to their end customers. Expensive bank loans discourage the borrower from availing credit.
  • This reduces the money supply in the market and thereby stabilizes the liquidity in the system. Consumption, Expansion and production also take a downfall with the lesser money supply. Expensive credit hinders economic development and GDP growth even though inflation rate comes under control.
  • Hence, Reserve Bank of India revises repo rate on a regular basis to keep the inflation rate under control and also to strike a balance between both economic growth and rising inflation.
  • Here are some of the vital impacts of increase in repo rate on economy:
  • Borrowing becomes costlier for banks as they avail short-term credit from Reserve Bank of India at relatively higher rate.
    – With the costlier credit for banks, they will ultimately lend the consumers at relatively increased rate. This may lead to costlier bank loans for customers. As the lending get expensive, borrower gets discouraged and demand for bank loan reduces.
    – Reduced borrowing results in lower consumption demand which will lead to economic slowdown that hinders the growth of GDP for the short term. As the consumption demand reduces, profitability of every sector in the economic system takes a hit.
    – Corporate loan buyers get discouraged to avail credit with the hike in repo rate also discourages the. As the availability of business capital becomes expensive, production and expansion plans of corporate take a backstop.
    – Increase in repo rate reduces the money supply in the economic system and thereby reduces the rate of inflation.
  • Reduction in Repo Rate:When Reserve Bank of India decides to cut the repo rate, the short-term loans for commercial banks become cheaper. This prompts them to offer consumer loans at a relatively cheaper rate.
  • Many a times, base lending rate gets reduced with the reduction in repo rate. Base lending rate is the rate below which banks cannot lend to its customers. Reduced base rate increases the consumption as people will have more money at their disposal.
  • Increased consumption positively impacts the country’s Gross Domestic Product (GDP) growth. Cheaper availability of credit encourages businesses to grow and expand. Prices of products get lower with the availability of low cost capital. New investments lead to better employment opportunity in the economy.
  • Here are some of the key impacts of repo rate cut on economy:
  • Consumption Demand: Demand for auto, housing and every sector will rise due to availability of cheaper bank loans to customer. Economic growth will take a upward trend with its every sector growing due to increased consumption demand.
    – Economic activities picks up: With the falling prices, economy grows at a slower rate. Repo rate cut boosts the economic activities and prompts healthy growth with adequate supply of money in the market.
    – Boost to foreign investments: Bank lending rates get reduced with the cut in repo rate. Lower borrowing rates will encourage the foreign players to investment in Indian financial market.
  • It’s crucial to note that the repo rate cut is not the only monetary measure for economic growth.

Difference between GDP and GVA:

  • While GVA gives a picture of the state of economic activity from the producers’ side or supply side, the GDP gives the picture from the consumers’ side or demand perspective.
  • Both measures need not match because of the difference in treatment of net taxes.
  • A sector-wise breakdown provided by the GVA measure helps policymakers decide which sectors need incentives or stimulus and accordingly formulate sectorspecific policies.
  • But GDP is a key measure when it comes to making cross-country analysis and comparing the incomes of different economies.

Conclusion:

  • The 25 basis points cut is, therefore, an acknowledgement by the MPC of the slowdown in growth.
  • The MPC’s neutral policy stance is prudent given the uncertainties ahead as it gives the central bank the flexibility to tailor policy to emerging data sets. 

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