Let me today, try to share with you, a Simpliifed Conversation, between 1 of our Favourite Character’s, whose jokes we are always surrounded by, in a way or Other.
Santa & Banta, once met & started a serious & sensible Conversation, to exchange thier Understanding on Macros & how they impact the Global Economies.
Santa: I have heard recently, that Mr. Rajan has reduced Repo Rate, by 50 basis points and everyone is saying that this is good for the market. Loan EMI may also come down. What this Rate cut means actually? I want to understand this.
Note: For awareness of those, who have not heard, about who Mr Rajan is, he is our Reserve Bank of India (RBI) Governor, who is the mind behind, framing/refining our Monetary Policy.
Banta: To understand this you first need to know, how does a Bank functions?
Santa: Why?
Banta: Because all these are inter-related. Tell me – What does a Bank do?
Santa: Bank takes Money from Depositors and gives Loan to earn Interest. That way, they keep everyone happy, and make a profit also.
Banta: Correct, but there is more to it.
Let me explain this in a very Simplistic way. Bank needs Money. Bank can get Money from depositors like you and me and also from RBI. But bank also needs to pay certain Interest to us and also to RBI.
Santa: Ok.
Banta: Let us try to understand first – What happens when we deposit, say, Rs. 100 with a Bank?
Santa: I know that. Bank gives that Rs. 100, to someone, who needs a Loan.
Banta: No, it is not that simple. Remember, though, Bank can earn Interest by giving away Loans, but it is also very risky. There are many cases of Loan Defaults. This way, Banks can put all our Money, into High Risk areas. It has to be protected.
Santa: How?
Banta: Ok, RBI has made it mandatory, that upon receiving, say, Rs. 100 – Banks first, have to deposit Rs. 4 with RBI. RBI keeps this Rs. 4 in its Current A/c and hence Banks do not receive any Interest on this Money. This is known as Cash Reserve Ratio or CRR, which is currently at 4%.
Santa: Hmmm, then?
Banta: RBI has also made it mandatory, that upon receiving, say, Rs. 100 – Banks need to compulsorily buy Central and State Govt. Securities of Rs. 21.50. Of course, Banks will earn some Interest Income here. This is known as Statutory Liquidity Ratio (SLR), which is currently at 21.50%.
Santa: Ok, so you mean to say that upon receiving Rs. 100, Banks can Lend only Rs. 74.50 at its own will.
Banta: Correct. 100 – (4 + 21.50) = 100 – 25.50 = 74.50
Santa: But you were saying that Banks can also borrow from RBI. What Interest Banks need to pay to RBI?
Banta: Before 30th September, Banks were paying 7.25% Interest to RBI, when they borrow Money from RBI. Now this Rate has been reduced by 50 Basis points. So Banks, now need to pay Interest to RBI, if they borrow from RBI, at the rate of 6.75%. This is known as Repo Rate.
Note:For awareness of those, who do not know, what a Basis Point is: In financial terms, ‘One’ Basis Point is a unit equivalent to 0.01% i.e. 1/100th of a percent. Thus 10 bps means 0.10% and 100 bps means 1%. BPs is mostly used to indicate the changes in Interest Rates and also Bond Yields.
Santa: Can Fixed Deposit (FD) rates, be affected by reduction of Repo Rate?
Banta: Of course. If banks get Money from RBI @ 6.75%, Why will Banks pay, higher Interest to you and me? One year FD rate is already revised by many banks and it is equal to or very close to 6.75%.
Santa: But as now Banks are getting Money, at a Cheaper Rate, then they should reduce the Loan Interest Rate as well (i.e. pass on the benefits, they are receiving).
Banta: Correct. They should. And on that hope only, Market (Stock Market) is cheering. If Companies, get Loan at a cheaper rate, they will likely to expand their Businesses. That will create more jobs, more Income (Disposable or Discretionary for Individuals & households) and in turn,boost the Economy.
Santa: How is Inflation linked to this?
Banta: See, when Loans becomes cheaper, people tend to borrow more. That means, people will have more Money to spend. This will increase the Demand for Goods, and if Supply does not increase to match this Demand, then prices will increase.
Santa: So there is a chance, that Inflation may rise also?
Banta: Well, yes. But Inflation depends on many other factors as well, like Production (Industrial and Agricultural), Manufacturing, Export – Import, Foreign Currency Movement etc. So Inflation may increase or may not.
Santa: One last Question. Like we deposit our Money with Banks, Can Banks also deposit their Money with someone?
Banta: Yes, they can deposit with RBI and earn Interest too. This Interest is typically 1%, less than the Repo Rate. This rate is known as Reverse Repo Rate.
Key Ingredients of Monetay Policy
Santa: Great! So now I understand CRR, SLR, Repo Rate, Reverse Repo Rate and their impact on Deposit Rate, Loan Interest Rate and on Inflation. Thanks.
Banta: Welcome!
Hope this help as well & each one of us, would now find it so easier, to Understand these basic Concepts of Macroeconomics & its Impact on Economy as a whole (Global Economy).
Bharat Sahni
PlanUrMoney 