RBI Repo Rate Cut: The Good, Bad and Worst

Dr Raghuram Rajan remind me of Harvey Specter from Suits… Not only both look dashing in their suits but also share similar trait of… Surprising the surroundings. So last week when Dr Rajan decreased the Repo Rate by 50 bps (.5% as 100 bps =1%) which was more than anticipated and asked, he was called Santa Clause and a Hawk. Media covered the event like cricket and confused political anchors tried to make understand the implication of this event making everyone more confused.

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Well our Harvey (Hemant) and Mike (Madhu) could not resist and sat in the morning to figure this comet which just passed the earth. Here is the transcript of their discussion:

Hemant: Dr. Rajan has reduced Repo Rate by 50 basis points and everyone is saying that this is good for the market. Loan EMI may also come down. Howthis repo rate cut means actually? I want to understand this. 

Madhu: To understand this you first need to know, how does a bank function. Because it is the interlinkages between the two very important function of bank viz source of fund and utilization of funds.

Hemant: Than tell me – what does a bank do? My understanding is primarily a bank takes money from depositors in form of deposits (Savings and FDs) and gives loan to earn interest. That way they keep everyone happy and make a profit also. 

Madhu: Correct, but there are more to it as bank has one more source of fund- RBI. Let me explain this in a very simplistic way. Bank needs money. Bank can get money from depositors like you and me and also from RBI. But bank also needs to pay certain interest to us and also to RBI. 

Hemant: Ok. 

Madhu: Let us try to understand first – what happens when we deposit, say, Rs. 100 with a bank. 

Hemant: I know that. Bank gives that Rs. 100 to someone who needs a loan. 

Madhu: No, it is not that simple. Remember, though bank can earn interest by giving away loans, but it is also very risky business. There are many cases of loan defaults in recent years and this increases banks NPA (Non-performing assets). This will make banks put all our money into high risk areas. It has to be protected. 

Hemant: How? 

Madhu: Ok, RBI has made it mandatory that upon receiving, say, Rs. 100 – banks first have to deposit Rs. 4 with RBI. RBI keeps this Rs. 4 in its current a/c and hence banks do not receive any interest on this money. This is known as Cash Reserve Ratio or CRR, which is currently at 4%. 

Hemant: Hmmm, then? 

Madhu: RBI has also made it mandatory that upon receiving, say, Rs. 100 – banks need to compulsorily buy central and state govt. securities of Rs. 21.50. Of course banks will earn some interest income here. This is known as Statutory Liquidity Ratio (SLR), which is currently at 21.50%. 

Hemant: Ok, so you mean to say that upon receiving Rs. 100, banks can spend only Rs. 74.50 at its own will. 

Madhu: Correct. 100 – (4 + 21.50) = 100 – 25.50 = 74.50 

Hemant: But you were saying that banks can also borrow from RBI. What interest banks pay to RBI? 

Madhu: Before 30th September, banks were paying 8.25% interest to RBI when it borrows money from RBI. Now this rate has been reduced by 50 basis points. So banks now need to pay interest to RBI, if it borrows from RBI, at the rate of 7.75%. This is known as Repo Rate. 

Hemant: Can fixed deposit rate be affected by reduction of Repo Rate? 

Madhu: Of course. If banks get money from RBI @7.75%, why will banks pay higher interest to you and me? One year FD rate is already revised by many banks and it is equal to or very close to 7.75%. 

Hemant: But as now banks are getting money at a cheaper rate, then they should reduce the loan interest rate i.e. passing on the benefits it receives. 

Madhu: Correct. They should. And on that hope market is cheering. If companies get loan at a cheaper rate, they will likely to expand their businesses. That will create more jobs, more income and boost the economy. However banks have not passed entire 50 bps to consumers.  

Hemant: How is inflation linked to this? 

Madhu: See, when loan becomes cheaper, people tends to borrow more. That means people will have more money to spend. This will increase the demand for goods, and if supply does not increase to match this demand, then prices will increase. 

Hemant: So there is a chance, that inflation may rise also? 

Madhu: Well, yes. That is why first RBI convinces itself that the demand will be catered by supply, than only they can reduce rates. Also this is the reason the rates are decreased or increased in tranches instead of one go decision. But inflation depends on many other factors as well, like production (industrial and agricultural), manufacturing, export – import, foreign currency movement etc. So inflation may increase or may not. 

Hemant: One last question. Like we deposit our money with banks, can banks also deposit their money with someone? 

Madhu: Yes, they can deposit with RBI and earn interest too. This interest is typically 1% less than the repo rate. This rate is known as Reverse Repo Rate. 

Hemant: Great! So now I understand CRR, SLR, Repo Rate, Reverse Repo Rate and their impact on deposit rate, loan interest rate and on inflation. Thanks. 

Hope this conversation explains the linkages between various rates governed by RBI but impacting our daily life. Madhu already mentioned that FD rates offered by banks will go down and have gone down. But some other impact is also created for various personal finance products. These are:

• Loans: If you are taking a new loan your EMI has come down… great news… but if you are already in loan this will not be a major impact. In case of floating rate loans the tenure will come down a bit but it’s not a relief as rates were already high and it just a catch up. Fixed loan takers will need to contact bank for a reset of EMIs.
• Debt Funds: The returns in short term will increase for G-Sec funds, Long Term Income Funds, Short Term Bond Funds and Liquid fund in the decreasing order mentioned. However long term returns would equalize to normal.
• Small Savings: The FDs and saving products like NSC and Post Office MIS will not be impacted immediately but cut is expected here also. Government has also indicated that PPF rates will be aligned to markets soon.
• Equity: Markets jumped to the offering but has no direct impact in short run. Banking/NBFCs companies and domestic housing sector will be on steroids. In long run the positive sentiments coupled with focus on sustainable growth will built a healthy atmosphere for Indian companies.

Hope you enjoyed reading this …. Feel free to ask questions or drop a suggestion in the comments section.