By: Rijul Durgaprasad Nadkarni (LT RLBU)
“My name is Raghuram Rajan and I do what I do”,
he says stamping his authority. He has been valiant and decisive in all the calls he has made, all in the betterment of the economy with curbing inflation being at the apex of his agenda. Ever since Mr. Rajan took over as Governor at India’s Central Bank , despite short falls by the UPA -2 and the declining worldwide economy , the Indian economy’s performance seems more or less reasonable, obviously helped by the falling crude prices but also due to some shrewd steps taken by Mr. Rajan. Largely appearing in the front pages of newspapers, terms such as inflation, commodity prices, current account deficit, rate cut, repo rate, Consumer Price index have dominated pages of Macroeconomics textbooks, which our Commerce friends claim to be ‘the chemistry of commerce’ seem mysterious to many. In this piece I’ll try to put forth some of these terms such that everyone develops at least a basic idea how the economy and banking system functions, so the next time you grab a newspaper, the sports section doesn’t buy most of your time (ladies can replace sports with the fashion or travel section – information obtained from valuable sources).
In one of his most recent manoeuvres, Mr. Rajan cut the repo rate by 50 basis points and suddenly the following questions arose:
How will it boost the economy?
How do banks benefit?
What is there in it for the common man?
What are basis points?
Luckily there was no “Who is Mr. Rajan?”
First things first, let’s understand how a bank functions. A bank lends money to those in need at a certain interest rate and gets money from depositors like us and the RBI. As they say, ‘there’s no such thing as a free lunch’, the bank is entitled to pay interest amounts to us and the RBI for depositing money with them. A Bank earns interest by giving away loans, but there are also loan defaults so in this way, we are ‘buying into ‘the bank’s risk in a way. Therefore, in order to hedge this risk, there’s something called CRR or Cash Reserve Ratio which currently stands at around 4%.
Let’s say banks receive an amount of Rs. 100, it is made mandatory that the banks first deposit an amount of Rs. 4 with the RBI which it maintains without paying any interest (This is the CRR) .Further RBI has also made it mandatory to invest 21.5% of the money deposited in central and state government securities on which they will earn an interest. This is known as Statutory Liquidity Ratio or SLR. So back to the 100 rupee example, deduct four and twenty one point five which leaves the bank about Rs. 74.5 to play with. Fair enough? Now part of our deposited amount is safe with the RBI in case of any failure on part of the bank.
Banks can borrow from the RBI too. Before September 30th 2015, banks had to pay interest at a rate of 8.25 % to the RBI when it borrows, but now it is reduced to 7.75 %, a reduction of 0.5% which is nothing but 50 basis points (1% is equivalent to 100 basis points) Bingo this is it! This is the rate cut!
The rate at which the RBI lends money to banks is called the Repo Rate. Now, if banks can get money from the RBI at 7.75 %, why would they want to pay a higher rate to let’s say a common man investing in an FD .Hence, this leads to banks reducing FD rates. As the banks accumulate money at cheaper rates, they should reduce the loan interest rate too to share its benefits. But why would one be so generous? We’re all here to mint some right? It doesn’t always work that way. In fact, this was the entire motive of the trimming the repo rate so that student loans, property loans and corporate loan rates reduce creating more business, jobs, income and a boost to the economy.
Conversely banks can also deposit money with the RBI and earn an interest on it too. This is typically 1% less than the repo rate and is called Reverse Repo Rate.
So where does inflation come in all this? Basically when a loan gets cheaper, people tend to borrow more and hence have more money in hand to spend, thus magnifying demand for goods. This puts pressure on the government and the corporate sector to increase supply to match this inflated demand failing which could lead to an increase in price (Simple law of demand – supply). ‘Increase in prices!?’ there you go, even inflation is dragged into the drama now. Well, inflation is too broad a term and depends on many other factors like production, manufacturing, export –import bills, foreign exchange rates, monetary policies implemented by other central banks like the Federal Reserve, the European Central Bank, People’s Bank of China etc., so inflation may or may not increase due to a rate cut.
With India’s export on the rise and import bills reducing mainly due to the diminishing crude oil prices and minimum demand for gold, our account deficit is in a much better situation than say August 2013 when the currency was in free fall. With India’s current account deficit and fiscal deficit projecting reasonable numbers, India’s growth prospects look bright with IMF predicting close to 7.5 % growth rate by the end of 2015. Great amounts of foreign currency is being pumped into the country in anticipation of greater returns. This has further reduced the pressure on the currency as can be seen with almost a null effect on the rupee despite the devaluation of the Yuan and the speculation about the Federal Reserve impending a rate cut. With the party in power marketing “Make in India” wholeheartedly, the production and manufacturing numbers are on an upturn from 2013-14 and these are signs of better times ahead for the Indian economy.
Lastly but not of least importance , agricultural income adds a substantial amount to our GDP and the Consumer Price Index (CPI) and Wholesale Price Index (WPI) play a pivotal role in governing the outcome of inflationary figures. Maintaining these at presentable levels is something which the RBI and the government need to jointly look into to highlight their long term mission of curbing inflation. Tweaking with the primary sector’s lending norms and increasing the number of bank branches lending in rural India could be a solution for starters. Such steps will boost agricultural figures in turn enhancing manufacturing output and making growth imminent.
With E-commerce and technology steadily making its mark which was starkly visible with the CEOs of various technological firms flocking for investment opportunities in India, our nation is now in a position to at least dream of concepts like smart cities , bullet trains etc. Transparent and efficient governance is the need of the hour which could take a country showing leaps and bounds of promise to a legendary status!