Every now and again we hear about RBI’s monetary policy review, the repo rate, the reverse repo rate the CRR, the SLR etc. But what do all these terms really mean? And how do they play into the economy of the country?
Lets start with the basics:
The repo (repurchase obligation) rate is the rate at which commercial banks borrow short term money from the RBI. Currently, it is 7.5%.
The reverse repo rate is the rate at which RBI borrows from commercial banks. The reverse repo rate is one percentage point (1%) below the repo rate. Currently it is 6.5%.
CRR (cash reserve ratio) is the portion of deposits banks have to keep with the RBI in cash. Currently it is 4%.
SLR (statutory liquidity ratio) is the amount of liquid assets or securities that commercial banks must maintain as reserves other than cash (with them). Currently it is 23%.
Now, any time that the RBI reduces any of these three rates, it leads to more money with the banks – which means more money for businesses to borrow, spurring growth of the economy. However, it also means more money for consumers to borrow (and spend), leading to inflation. Hence the monetary policy is always a tightrope walk between inflation and growth.
Alongwith the monetary policy, various govt. policies also affect growth and inflation. For example, if the RBI cuts rates, and the govt. cuts subsidy on cooking gas, then consumers do have more money to spend but they end up spending it on the now more expensive gas, thus not causing inflation on other fronts.
Between March 2010 and October 2011, the RBI raised the repo rate 13 times (to reach 8.5%) to suck money from the system and control inflation, albeit at the cost of affecting growth. Then in April 2012 the repo rate was cut by 0.5% (to 8%). The rationale behind the 0.50% cut was to force the govt.’s hand to take appropriate fiscal measures, and support the monetary policy. Important measures that were expected from the govt. include a cut in subsidies and economic reforms that would ease supply-side constraints. Such steps called for a strong political will as well as support from the UPA’s coalition partners. It was, therefore, highly unlikely that these would happen before 2014. So, the RBI’s wish-list was intended to highlight the crucial dependence of monetary policy on fiscal measures, and the RBI’s helplessness in the face of fiscal profligacy.
Traditionally, the RBI influences interest rates by changing the policy rates (repo and reverse repo), however, since April 2012 the RBI has chosen to use the liquidity augmenting CRR reductions. Industrial houses were not very pleased with this method since they feel that that banks do not pass on the benefits of CRR cut to the industry; that the CRR cut will only benefit the banks and not the industry, which is suffering from high interest rates and slow demand.
Then in Jan 2013, the RBI decided to reduce the repo rate to 7.75% (after April 2012) to placate industry. Another reason that the RBI decided to reduce the rate was that the government had finally begun to heed the RBI’s persistent call for fiscal discipline to complement its anti-inflation measures. A number of “feel-good” policy measures had been announced to revive the economy, which it was hoped, will impact favourably on public finance. The Finance Minister had quite explicitly been committing to a fiscal deficit of around 5.3 per cent of gross domestic product (GDP), with promises of more drastic reductions in the near future. If the government has started to act could the RBI have stayed put with unchanged policy rates? When growth had been declining by various parameters, it called for an easier interest rate policy. And, quoting from the RBI’s policy paper –
“With headline inflation likely to have peaked and non-food manufactured products inflation declining steadily over the last few months, there is an increasing likelihood of inflation remaining range-bound around current levels going into 2013-14. That provides space, albeit limited, for monetary policy to give greater emphasis to growth risks.”
Now, coming to the March 19th policy review; India’s GDP growth in Q3 of 2012-13, at 4.5 per cent, was the weakest in the last 15 quarters. What is worrisome is that the services sector growth, hitherto the mainstay of overall growth, has also decelerated to its slowest pace in a decade. Also, The Union Budget for 2013-14 has made a firm commitment to fiscal consolidation. According to the revised budget estimates for 2012-13, the gross fiscal deficit (GFD)-GDP ratio, at 5.2 per cent, was contained around its budgeted level, mainly by scaling down plan and capital expenditures. The GFD-GDP ratio is programmed to decline to 4.8 per cent in 2013-14 and further down to 3.0 per cent by 2016-17, in line with the revised road map for fiscal consolidation. Thus, as the RBI saw fiscal policy support from the govt. and the growth slowdown needed to be addressed, it decided to further reduce the repo rate to 7.5%. The CRR remains unchanged at 4%.
An article about the CRR and the recent controversy whether it should be scrapped shall follow soon..
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