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Tuesday, June 18, 2013

Why RBI Did Not Cut Interest Rates?



The common man too was waiting for this day as India’s central bank RBI was supposed to come up with its mid-quarter review of the monetary policy for the June quarter. (Q1).
What he wanted from the RBI governor was a reduction in Policy Rates and ReserveRatios so that his EMIs (Equated Monthly Instalment) on home and other loans would have slashed.

Unfortunately, RBI governor did not reduce the Policy Rates or Reserve Ratios.

The main policy rate is the Repo Rate- the rate at which RBI lends to commercial banks. Commercial banks often borrow money from the reserve bank and when this rate is lowered commercial banks can reduce their lending rates. The RBI governor kept this rate unaltered at 7.25 %.

The other ratio which was expected to be reduced was the CRR or Cash Reserve Ratio- the percentage of total deposits that commercial banks are supposed to park with the reserve bank.
As, no interest is payable on CRR, commercial banks expect this obligation to be minimum.

When CRR is reduced, a significant amount of the deposit gets unlocked and the same can be used for lending. When there is a scarcity of lendable capital, interest rates tend to soar and the vice-versa. The CRR too stands unaltered at 4%.

So, when the Repo Rate and CRR are high, in order to reduce lending rates banks need to reduce deposit rates i.e. the reduction in the interest payable on time deposits like FDs, RDs etc.

Then why banks are not reducing the deposit rates?

This move is not possible as investors are not readily depositing money in banks and instead investing in gold and real estate where they have seen a significant appreciation in the past several years.
If deposit rates are reduced then investors shall be withdrawing money from banks to invest in other asset classes where returns are higher.
Presently, CPI (Consumer Price Index) based inflation is 9.3 % while the maximum interest rate on bank deposits is in the range of 8.75 %-9 %, and therefore the Real Interest Rate (the difference between payable Interest rate on an instrument and the prevailing inflation rate) is -.3 %.
This means investors are not making money from bank deposits but they are in fact losing a little fraction of it.
If banks shall reduce the deposit rates then this RIR shall fall further and investors shall be withdrawing more money from the already liquidity-starved banks to aggravate the liquidity.

Why RBI did not slash rates?

(1)    As CPI inflation is much above the RBI’s comfort zone of under 6%, RBI hesitated to cut the rates. By reducing rates money supply in the economy increases and inflation shoots up.

(2)    Other problem was posed by the weaker rupee. Had RBI reduced the policy rates, bond prices would have shot up reducing the bond yield. A reduction in the bond yield makes foreign investors sell Indian bonds and take their dollar funds back. And this departure of the dollar would have further weakened the rupee.

(3)    Weaker currency increases the CAD (Current AccountDeficit) and India’s is already having a high Trade Deficit too and these higher deficits often drive rating agencies to downgrade the credit rating. A lower credit rating means newer foreign debt at higher interest rates and higher interest outlay increases the CAD further leading the Indian economy into a negative spiral.
RBI took the right decision and desisted from cutting rates. Higher deficits are due to India’s faltered and populist fiscal policy and this is why RBI adopts a hawkish monetary policy to protect the economy.

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