Even with repo rate cut by RBI, in­ter­est rates won’t fall

DNA (Daily News & Analysis) Mumbai Edition - - FRONT PAGE -

he news about the bud­get fiz­zled out so quickly,” she said.

“Oh yes,” I replied. “With so many things de­mand­ing at­ten­tion, peo­ple move on very quickly these days.”

“And what do you think about the Re­serve Bank of In­dia (RBI) cut­ting the repo rate from 6.5% to 6.25%?” “What about it?” “Will it lead to banks cut­ting in­ter­est rates?”

“Be­fore I get into that, what is the repo rate?”

“Ah, there you go again,” she said. “Test­ing me as usual.”

“Come on, hu­mor me.”

“Repo rate is the in­ter­est rate at which the RBI lends to banks.”

“Right. And why has the RBI cut the repo rate?”

“Sim­ply be­cause in­fla­tion has been low. In De­cem­ber 2018, it was at 2.19%, an 18-month low.”

“Right. And what is the link be­tween in­fla­tion and in­ter­est rates?”

“In­fla­tion is ba­si­cally the rate at which prices rise. If peo­ple are buy­ing more goods and ser­vices, prices tend to rise, be­cause the de­mand goes up quickly, while the sup­ply doesn’t. In this case, in or­der to slow down de­mand, the cen­tral bank raises the repo rate, in the hope that peo­ple will bor­row and spend less, and this will push down de­mand, and hence, in­fla­tion will fall.”

“Ex­cel­lent. You have turned into a proper econ­o­mist.”

“Along sim­i­lar lines, when in­fla­tion cools, the cen­tral bank goes easy on the repo rate, and slashes it; which is pre­cisely what the RBI has done.”

“Good. So, what hap­pens now?” I asked.

“With the RBI cut­ting the repo rate, banks will cut in­ter­est rates on their de­posits and in turn on their loans, and this will lead to higher bor­row­ing and spend­ing. This will pump up the econ­omy,” she ex­plained.

“This is where you stop be­ing an econ­o­mist and be­come a politi­cian.”

“As in?”

“All politi­cians ever want is that the cen­tral bank cut the repo rate. No politi­cian ever talks about the cen­tral bank rais­ing in­ter­est rates.” “Hmmm.”

“There are two things here. In­fla­tion has been low pri­mar­ily be­cause food prices have been fall­ing. And there is noth­ing the RBI can do about that. In fact, if you look at non-food non-fuel in­fla­tion, it is close to 5.5%, which is slightly on the higher side.”

“And the sec­ond thing?” she asked.

“A repo rate cut is at best an in­di­ca­tor by the RBI that it ex­pects in­ter­est rates to come down in the days to come.”

“But that may or may not be the case?”

“Yes. It de­pends on how banks are placed in­di­vid­u­ally.” “Which means what V?”

“It ba­si­cally means that banks raise de­posits to give out as loans. If they are giv­ing out more or less all the de­posits that they have as loans, af­ter meet­ing the reg­u­la­tory re­quire­ments, then they need more de­posits in or­der to con­tinue giv­ing out loans. In this sce­nario, they will have to raise in­ter­est rates to at­tract more de­posits, ir­re­spec­tive of the sig­nals be­ing sent out by the RBI.

In this sce­nario, they will have to raise in­ter­est rates, ir­re­spec­tive of the sig­nals be­ing sent out by the RBI.”

“And how is the sit­u­a­tion now?” “As on Jan­uary 18, which is the lat­est data avail­able, the credit de­posit ra­tio of banks was at 77.8%.” “So?” she asked.

“This means that for ev­ery Rs 100 raised by a bank as a de­posit, nearly Rs 78 had been given out as loans. The banks need to main­tain a cash re­serve ra­tio of 4%, which means they need to de­posit Rs 4 out of ev­ery Rs 100 they raise as de­posit, with the RBI. Over and above this, the banks need to main­tain a statu­tory liq­uid­ity ra­tio of 19.25%, which means for ev­ery Rs 100 raised as a de­posit, banks need to in­vest Rs 19.25 in govern­ment se­cu­ri­ties of dif­fer­ent kinds.” “Hmmm.”

“Ba­si­cally, banks are al­ready stretched when it comes to their de­posits. They are vir­tu­ally lend­ing out al­most all of it. In this sce­nario, chances that banks will lower in­ter­est rates on their de­posits and in turn, on their loans, are very low. In fact, many banks have raised in­ter­est rates on their de­posits, in the re­cent past.”

“Is that the case?”

“Pretty much.”

“It makes me won­der, why the politi­cians are still talk­ing about lower in­ter­est rates then.”

“Well politi­cians are politi­cians, they will al­ways talk,” I replied.

The ex­am­ple is hy­po­thet­i­cal. (Vivek Kaul is the au­thor of the

Easy Money tril­ogy).

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