RBI Policies: Common Man's Take

Around the time of an RBI policy review meet, market participants and the media are abuzz with expectations on policy change, what tools would be used and to what extent. Soon after the meet, news streams on market reactions tell you how well the policy outcome went with them.

Yesterday, on 2nd December 2014, in its fifth bi-monthly monetary policy statement for 2014-15, the central bank RBI left key rates unchanged: Repo rate @ 8%; Reverse Repo @ 7.0%; Cash Reserve Ratio @ 4.0%; MSF Rate and Bank Rate @ 9.0%. This appeared much in line with the expectation of industry watchers and fund managers.

As common people many of us would not spare even a glance for such news which, as it does, grabs the front page of all financial newspapers. However the fact is that the impact of any monetary and credit policy measure eventually trickles down to everyone in the country. Why? Because these measures effectively alter the cost of money i.e. interest rates and/or regulate the flow of money in the monetary system, which includes banks and end borrowers like us.

To crack the code of RBI’s policy moves one would need to know the various monetary and credit policy tools employed by it. Broadly, the RBI uses the following tools to achieve its stated objectives which are explained below for your understanding -

A. To signal Interest Rate levels in the banking system -
• Repo Rate - It is the rate at which banks borrow from the RBI. An increase in the rate would signal a higher cost of funds for banks and thus for all borrowers. Over time, a continued increase in the Repo rate would lead to an increase in the interest rates on fixed deposit as well as on loan products. And vice versa. So, the higher the rate, the higher would be the general level of interest rates. The Repo rate is usually hiked as a response to rising inflation and to curb inflation expectations.

• Reverse Repo Rate - It is the rate at which the banks lend to RBI. This rate acts as a floor for interest rates as the RBI itself is ready to borrow at this rate. The Reverse Repo rate is now set at 100 bps (1%) below the Repo rate. As the Repo rate is changed, the reverse repo rate automatically changes.

• Marginal Standing Facility (MSF) - The MSF rate is set at 100 bps (1%) above the Repo rate. It is viewed as a penal rate and is used by banks when fund availability is tight and demand for funds increases thus forcing them to borrow at the higher rate from the RBI.

The current Repo rate is 8% and hence the Reverse Repo rate is 7% and MSF is 9%. Most often, RBI thus uses only the Repo rate to signal changes in its monetary policy. But in rare instances it also uses the Reverse Repo and MSF to signal its stance.

B. To control liquidity; credit flow and money supply in the economy -
• Cash Reserve Ratio (CRR) - It is the amount of money (as a % of net deposits) the banks need to maintain as a reserve with the RBI. If the RBI intends to reduce the amount of money in the banking system (tighten liquidity) it would increase the CRR and vice versa. A higher CRR rate would mean that banks have lesser money to lend. The CRR is currently at 4%

• Statutory Liquidity Ratio (SLR) - It is the amount of money (as a % of net deposits) the banks need to maintain by investing in government and state government securities. Banks are mandated currently to invest 22% of its (net deposits) in SLR securities

• Open Market Operations (OMO) - As banks are the biggest owners of bonds issued by the government (government securities or G-Secs), the RBI would buy G-secs (OMO purchases) from banks to increase the liquidity in the system or sell its stock of G-secs (OMO sales) to drain out excess liquidity from the banking system.

The RBI can use many other tools to regulate the credit flow to corporate and individual borrowers like Risk Weights & Provisioning Norms but to avoid complication we would avoid discussing them.

Thus in a nut shell RBI policy moves are like the steering wheel of the banking industry. Given this what is the impact on you as an individual?

For borrowers, it is bank lending rates which matter more than market yields of debt securities. In the last 3 months bond market and money market yields have fallen sharply, but banks have not reduced lending rates. However RBI is pro-actively providing liquidity and as the RBI gets more comfortable on the inflation trajectory, which has cooled down considerably, liquidity will be made even easier. Banks’ funding costs could fall even more in the coming months, allowing them to cut lending rates along with the easy monetary policy stance.

For savers in fixed deposits, since the repo rate will hold @ 8% for some more time, one can expect deposit rates to remain around the current 8-9% mark. This when seen from the reported and expected CPI inflation levels for next year; the 9% rate seems definitely attractive. It may be prudent to increase the tenor of your fixed deposit investments beyond the 1 year and lock into these rates for longer tenors.

The same holds true for investors in money market through liquid funds. Given that RBI will hold interest rates @ 8%; bond yields at or near the 8% rate one can invest in these since CPI inflation is now at 6% levels.

Hope you have got the gist of how RBI policy changes affect our savings, investment and borrowing. In case of queries on this please feel free to contact us. You can give a missed call on 022-61073807 and we will be glad to get back to you.

Source: RBI

Above article is authored by Quantum.

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