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Recently we came across these news’ “Repo Rate cut by 50 bps”, Raghuram Rajan saying “You call me hawk, some call me Santa Claus; I am Raghuram Rajan and I do what I do”. Every news channel and news magazines went crazy and covered this story. So, why is this repo rate so important? How is it going to affect us? In addition to repo rate, various other policy rates also faced a change.

Let’s have a look at all these rates and learn how they affect a consumer and the economy.

POLICY RATES:

  1. Repo Rate-

Repo Rate is the rate at which banks borrow from RBI (The central bank) in case of shortfall of funds. The loan can be kept for a good amount of time when compared to loans taken by way of MSF (Marginal Standing Facility). If a bank is borrowing under Repo Rate, it needs to pledge some government securities with it. Let’s take an example to understand how it works:

Suppose a bank is in need of ₹100, now imagine the margin requirement for loan is set at 20% (It is the difference between the loan value and the market value), this implies that the banks will be provided loans of only 80% of the securities. So, accordingly the bank will have to pledge the securities amounting to ₹125 to get a loan of ₹100. During the repayment, banks need to pay an amount = Amount taken as loan + Repo Rate.

However, these securities must not be included in SLR (Statutory Liquidity Ratio). Banks need to provide additional securities. Currently the Repo Rate stands at 6.75%

How does it affect a consumer and economy?

RBI uses the tool of repo rate to curb inflation. Suppose that RBI increases repo rate, this implies that banks would get loans at higher interest rates and therefore they will provide loans to consumers at higher interest rates (because of their increasing costs), and since the loans would be costlier people would demand less and if they would be having less money, the spending would be less. And following the laws of demand and supply, if demand falls and supply remains the same then prices are bound to fall and hence inflation stays under control. And if RBI decreases the repo rate then the effect would be exactly opposite, i.e., prices would rise.

So, the question here arises that why did Raghuram Rajan decreased the repo rate by 50 bps if it will increase the inflation?

RBI took the advantage of easing inflation to boost the economy growth. Even if inflation rises, that won’t be a problem these days. So the motive of the RBI governor was to give a boost to the manufacturing sector which is still lagging behind and thus help in quick economic growth of India (which is expected to be at 7.4% for the next quarter).

  1. Reverse Repo Rate-

There comes a time when banks have extra deposit against which they have no loans, so banks prefer parking these extra funds with RBI and earn some interest as well. This type of interest rate is known as Reverse Repo Rate. This is usually kept at 100 bps lower than the Repo Rate. Currently it is 5.75%

Suppose a bank deposits ₹100 with RBI, so after a period of time it will get the amount = Amount deposited + Reverse Repo Rate, in this case it would be ₹105.75

How does it affect a consumer and economy?

If RBI increases the reverse repo rate this implies that banks have a good incentive to park their funds instead of lending and therefore less funds would be available for the consumer to borrow and thereby RBI can control money supply in the market. And if, RBI lowers this rate, this will discourage banks to deposit their funds with RBI and therefore they will lend more and hence money supply would rise.

  1. Bank Rate-

It is the rate at which central bank lend funds to the commercial banks. It is used when funds are required for a comparatively longer period of time. Difference between repo rate and bank rate is basically that unlike repo rate, we don’t need to pledge any type of securities. Bank rate is charged on the amount of the loan taken. It usually kept at 100 bps higher than the repo rate. Currently, it is 7.75%

How does it affect a consumer and the economy?

Bank Rates have a direct impact on the lending rates. If RBI increases bank rate, then the lending rates of commercial banks will also rise and vice versa. Increasing lending rates would lead to less demands for loans, and decreasing lending rates would lead more demands for loans. This way RBI regulates the market rates, by changing bank rates according to the requirements.

  1. Marginal Standing Facility Rate (MSF)-

It is the rate at which commercial banks borrow money from RBI, the concept is same as the repo rate, except one thing. In repo rate, one has to pledge securities additional from SLR, while in MSF, one can provide securities which are already included in SLR, hence no need to buy new securities. So even if SLR goes below the required rate due to pledging securities under MSF, banks need not pay any kind of penalty which otherwise they would have.

Banks can borrow upto 2% of Net demand and time liabilities (NDTL)*, funds are borrowed in case of emergencies on an overnight basis. MSF is always kept 100 bps higher than the repo rate.

Currently, it is 7.75% 

How does it affect a consumer and the economy?

The implication is very simple. Increasing MSF, would lead to costlier borrowing which banks will transfer onto the consumer and hence loans become costlier and vice versa.

*NDTL- Bank accounts from which you can withdraw money at any time is known Demand Liabilities and accounts from where you cannot withdraw money anytime is known as Time Liabilities (These are being called liabilities from the point of view of banks)Suppose you deposited ₹X as demand and time liabilities and taken out ₹Y from them then NDTL would be ₹(X-Y).

RESERVE RATIOS: 

  1. Cash Reserve Ratio (CRR)-

It is the minimum amount of the total deposits which commercial banks are mandated to keep either as cash or as deposits with the central bank. The idea behind CRR is that banks should not run out of cash, nobody is sure about how many borrowers might turn up to get back their money so CRR keep the bank on the safer side.

Currently, CRR is fixed at 4%

How does it affect a consumer and the economy?

CRR is the tool of central bank to control the money supply in the economy. Suppose RBI increased CRR, this implies that banks will need to deposit more cash as compared to the previous situation, therefore banks will have less money to lend and hence money supply would be restricted; Vice versa would happen if RBI decreases the CRR.

  1. Statutory Liquidity Ratio (SLR)-

Statutory Liquidity Ratio says that banks need to keep a certain percentage of funds invested in gold or government approved securities before providing credit to its customers. Penalty is imposed on banks if they fail to maintain this much of percentage.

Currently, SLR is 21.5%

 How does it affect a consumer and the economy?

SLR ensures the safety of banks and that they invest in government securities. It controls the credit growth of the economy. The implications are rather similar as CRR, the difference between the two is the form in which banks are supposed to keep their money; while CRR directs banks to keep some deposits in form of cash, SLR directs them to invest some funds in gold or government securities.

The above were the various rates and ratios managed by the central bank. Hope it helped. Feel free to ask any queries or provide any suggestions!

Thank you 🙂

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