Story Of The Week

RBI’s Monetary Policy Review: Repo Rate Cut and Its Impact

The Reserve Bank of India cut its benchmark repo rate by 25 bps to 6.5 percent during the meeting held on April 5th, 2016. It is the first reduction since September 2015 and the lowest rate since January 2011. At the same time, the bank surprisingly raised the reverse repo by 25 bps to 6.0 percent while ensuring more availability of cash in the banking system by reducing the cash proportion of their daily reserve requirements and maintaining the cash reserve at 4.0 percent.

Interest Rate in India has averaged 6.71 percent from 2000 until 2016, reaching an all-time high of 14.50 percent in August of 2000 and a record low of 4.25 percent in April of 2009.

interest rate

Figure 1: Interest Rate Variation

Despite the Reserve bank lowering rates by 125 basis points since 2015, banks have reduced rates only by close to 60 basis points. The RBI has expressed concerns and is keen to ensure that the benefits of a rate cut translates into lower borrowing costs for firms and individuals.

The RBI Governor has announced few structural changes in the central bank’s liquidity management policy with banks complaining of liquidity. To address this, RBI has reduced the Marginal Standing Facility or MSF by 75 basis points while also easing the requirement of maintaining a minimum daily cash reserve ratio — from 95 to 90 per cent. The move is aimed at helping the banks struggling with liquidity problems.

 Impact on Finances

The rate cut means different things to different segments. Existing and potential home loan customers are delighted because it brings down their borrowing costs. Corporates are pleased because their cost of capital comes down and stock investors see this as a positive development. At the same time, investors in fixed income instruments are a worried lot because banks have brought down their deposit rates.

  1. Effect on consumers: A fall in the bank interest rate will encourage one to save less and spend more. Due to low interest rate, loans, particularly home-loans will see a rise and this benefits the real estate market. Similarly, cheaper car loans and student loans will also push demand in these segments. Lower interest rates also mean that people would lose out on a higher return on their fixed deposits as banks reduce rates proportionately to protect their margins. Pensioners who depend on bank deposits will be the worst affected in a low interest rate cycle.
  1. Effect on Equity Markets: The positive impact on consumption and lower interest outgo would mean high profits and thus better valuations for the equity market. Also, lower interest rates means that money will move from lower yielding debt instruments to the risky, but high return yielding equity market.
  1. Increased Job Opportunities: As capital becomes cheaper, companies will tend to expand their operations, thus, generating employment as they would require more manpower. This coupled with government’s reforms will increase industrial output, and hence produce more jobs in the market.
  1. Advantage for Existing Borrowers: Starting 1st April, Marginal cost-based lending rate (MCLR) which would replace base rate linked with lending in due course of time. Existing borrowers will now enjoy the advantage of Repo rate cut, and will be allowed to move on to new MRCL Structure which they previously could not.

The Way Forward

Dr.  Rajan has promised that the monetary stand will be accommodative and RBI will keep a strict watch on the persistence of inflation in certain services. However a tepid global demand, government’s effective supply side measures to keep a check on food prices and Government’s fiscal discipline still pose a challenge to RBI’s new monetary policy. With the hope of a normal monsoon, continuation of soft commodity prices and hope of government delivering on fiscal prudence, investors might still hope to see further rate cut by RBI in future.

References:

  1. http://economictimes.indiatimes.com/wealth/borrow/rbis-25-bps-rate-cut-happy-times-expected-to-continue-for-borrowers/articleshow/51695391.cms
  2. http://www.business-standard.com/article/finance/rbi-policy-review-here-s-how-0-25-rate-cut-will-affect-you-116040500959_1.html
  3. http://indianexpress.com/article/business/banking-and-finance/rbi-cuts-repo-rate-by-25-basis-points-to-6-5/
  4. http://www.dnaindia.com/money/report-realtors-look-at-banks-to-cut-interest-rates-2198690
  5. http://www.financialexpress.com/article/industry/banking-finance/rbi-cuts-interest-rate-by-50-bps-home-loans-set-to-become-cheaper/143129/
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