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Figuring the rate cut conundrum

On the heels of the wholesale price inflation touching a 3-year low of 7.18% in December, the RBI has brought the industry cheer by slashing key policy rates, after a 9-month wait. Gaurav Choudhury reports.

business Updated: Jan 29, 2013 22:48 IST
Gaurav Choudhury

On the heels of the wholesale price inflation touching a 3-year low of 7.18% in December, the RBI has brought the industry cheer by slashing key policy rates, after a 9-month wait.

What has the Reserve Bank of India (RBI) announced on Tuesday?
It has slashed the repo rate and the cash reserve ratio (CRR) by 0.25% points to 7.75% and 4% respectively.

What is the repo rate?
It is the rate at which the RBI lends to banks.

How does repo rate influence interest rates that banks charge from customers?
A lower repo reduces banks’ borrowing costs, allowing them to cut interest rates for final home, auto and corporate borrowers.

So, can consumers expect their EMIs to come down?
Not immediately. A lower repo will bring down costs for banks, but banks usually offer lower interest rates only for new customers initially. Existing home loan borrowers who have borrowed money on floating rates will have to wait longer before banks actually bring down their EMIs.

What about loans on automobiles and consumer goods?
Automobile and consumer goods loans are all on fixed interest rates and, therefore, existing customers are not affected by changes in RBI’s policy rates.

What if I have an existing home and want to shift to a new loan offered by a different bank at a lower interest rate?
RBI had already banned banks from levying foreclosure charges or pre-payment penalties on home loans on a floating interest rate. This implies that if you want to close an existing loan by borrowing from another bank as it is charging lower interest rate, you would not be required to pay any penalty to the first bank.

What is CRR?
CRR is the proportion of deposits that banks have to park with the central bank.

What does a CRR cut aim to achieve?
A cut in CRR aims to allow banks to unlock funds for lending. According to estimates, the 0.25% point cut in CRR will allow banks an additional Rs.18,000 crore to lend.

Does a reduction in CRR reduce borrowing rates for customers?
Maybe, but in a very indirect way. With more cash in hand to lend following the cut in CRR, banks may not need to woo customers by offering higher interest rates to shore up their deposit base.

Some banks may even consider lowering the interest they pay to customers on their fixed and savings deposits to cut costs. Lower costs, in turn, could prompt them to reduce their final lending rates

What is reverse repo rate?
It is the rate at which RBI borrows from banks to absorb or release cash from and into the system. The reserve repo rate is always one percentage point lower than the repo rate. It currently stands at 6.75%

How does it influence banks’ lending rates?
At a higher reverse repo, the central bank would suck cash from the system to stymie demand and cool prices. A lower reverse repo implies that banks would be encouraged to lend to other borrowers to earn more rather than park its funds with the RBI that will fetch it lower returns.

What are policy rates?
The policy rate acts the guide for final lending rates that banks charge from borrowers. In tight liquidity situations, the repo rate acts as the policy rate.

In situations of excess liquidity, when banks park money with the RBI from their pool of lendable resources, the reverse repo rate acts as the policy rate.

What prompted the RBI to slash policy rates?
The RBI uses monetary tools to stymie demand and cool prices. The tug-of-war between sliding growth and rising inflation — which has forced the RBI keep interest rates high — appear to have hurt consumption demand, a strong edifice of the India growth story and corporate investment.

India’s factory output contracted by 0.1% in November, pulled down by poor manufacturing and capital goods output mirroring weak investment activity, as firms held back capacity expansion plans, hemmed in by high interest and costly raw material.

Can we expect more interest rate cuts in the coming months?
Wholesale price index (WPI)-based inflation, India’s most watched cost of living index, touched a three year low of 7.18% in December and the central bank expects prices to moderate further.

The central bank has said that moderation of prices provides space, albeit limited, for monetary policy to give greater emphasis to growth risks.

However, if inflation remains high, the RBI may hold back further repo rate cuts.