Latest monetary stimulus from RBI: Repo and reverse repo slashed - Atasi Das

March 16, 2009

The recessionary phase shows little signs of abatement now. Sagging employment and output levels in developed nations like USA, Japan and the Euro zone have failed to rise since last year. Governments around the world, including that of emerging economies such as India, have opted for expansionary fiscal policies for combating the adverse effects of the economic slump. The Reserve Bank of India, the country’s apex monetary body, has also kept a close tab on the ongoing international and national economic developments and initiated various policy measures as and when needed.

The rate cuts:

In India, though the financial markets have been functioning relatively smoothly, the country’s growth statistics have taken a beating. With a view to maintaining sufficient liquidity in the system, the RBI, since mid-September 2008 has indulged in various rate cuts involving the repo rate, reverse repo rate, cash reserve ratio, NDTL and SLR.

The repo rate and the reverse repo rate changes have been executed under the liquidity adjustment facility (LAF). Repo rate is the rate of interest at which the RBI lends to commercial banks. Reverse repo rate is that rate of interest at which the RBI borrows from these commercial banks. These are the benchmark interest rates of the economy. Borrowers are affected by these interest rate changes depending upon the extent to which the commercial banks pass on the benefits or costs of loans to their customers.

The abovementioned rate cuts, which have been implemented by the RBI in a phased manner since mid–September 2008 till date are listed below.

• Scaling down of the repo rate to 5.5% from 9%

• Downsizing of the reverse repo rate to 4% from 6%

• Reduction of the cash reserve ratio to 5% from 9% of NDTL (net demand and time liabilities) and that of SLR to 24% of NDTL from 25% of the same

Again, on 4th March 2009, the RBI further slashed the repo rate and the reverse repo rate by 50 basis points each, with immediate effect. The repo rate currently stands at 5% while the reverse repo at 3.5%.

Current economic backdrop:

Inflationary pressures have eased out considerably for the Indian economy, at present. WPI (wholesale price index), which stood at 12.91%, on 2nd August 2008, has declined sharply to 3.36%, on 14th February 2009. However, there has been no such dramatic reduction for consumer price inflation, which hovered between 9.85-11.62% in the December 2008-January 2009 period. It is expected to decline, albeit with a lag. One prime cause for concern, for the RBI has been the gradual decline in economic activities. Real GDP growth, as estimated by the CSO had nosedived to 5.3%, for the September-December 2008 period; with the services sector experiencing a major slow down. Private investment has also decelerated significantly. Exports have recorded a negative growth in the period from October 2008 to January 2009. IIP (index of industrial production) recorded a 2% negative growth in December 2008 and the manufacturing sector itself recorded a 2.5% negative growth.

While recognizing the need for pumping in extra liquidity to boost the economy’s sagging consumption and investment demand, the Reserve Bank of India has urged the commercial banks to carefully check the viability of funded projects, alongside with improvement in asset quality. Until now, the commercial banks, in particular the foreign and private ones have been reluctant to pass on the entire benefits of the rate cuts to the borrowers. As per RBI, the commercial bank’s reluctance to lend to industry in general over the last 3 months has build up a domestic credit crunch. Availability of credit for non food items has decelerated since December last year.

Effects of rate cuts:

• The RBI’s key benchmark rate cuts will eventually lead to a fall in all types of interest rates, if the banks pass on the benefits to the borrowers
• Fixed deposits holders are likely to be affected with a decline in interest rate earnings
• Latest rate cuts are also aimed at stabilizing the volatile debt market
• The government, presently considering a substantial market borrowing operation (to finance its heightened expenditure) is likely to benefit from the reduced interest rates.

Industry opinion:

Chanda Kochhar, the CEO-designate of ICICI Bank has hailed the RBI benchmark rate cuts. However, criticism has come from people like Mr. Suresh Tendulkar, chairman of the Prime Minister's Economic Advisory Council, who holds that the banking system possesses sufficient liquidity, but has till now exhibited risk averse behavior regarding credit extension. According to Mr. Ashish Parthasarthy, the Dy Head Treasurer of HDFC Bank, an economic slowdown affects borrower creditworthiness; hence irrespective of the repo cuts, commercial banks are at present fairly conservative about advancing loans. Industry analysts predict that the banks will follow a go slow policy regarding interest rate reduction in the current fiscal; some may even keep their interest rates unchanged.