Understanding the repo rate, cash reserve ratio and the Reserve Bank of India
The Reserve Bank of India (RBI) on Tuesday cut the repo rate as well as the cash reserve ratio (CRR) by 25 basis points, or 0.25 percent. Here’s a quick explanation of what that means. It will be obvious to some readers, but many people haven’t studied economics and are unfamiliar with the terms.
The repo rate, which now stands at 7.75 percent, is the rate at which the central bank lends money to Indian banks. As the repo rate goes down, it gets cheaper for banks to borrow money. That makes it easier for people to borrow money at cheaper rates too. As more people borrow money, which ought to be the result of action like this, they’ll spend more money. That’s good for the Indian economy.
The CRR, meanwhile, is the amount of funds banks must keep with the RBI. The CRR is at 4 percent, which means for every 100 rupees, the bank keeps 4 rupees with the RBI in cash. The ratio indicates the policy stance of the bank and is used as a tool to manage liquidity, or the amount of money in the system. By changing this ratio, the central bank can control the amount of liquidity. Tuesday’s cut would release 180 billion rupees (or about $3.35 billion) into the system, meaning banks would have more money to lend to borrowers.
Cutting the repo rate doesn’t always cut lending rates, of course. Banks might worry that lower lending rates could hurt their profits. However, IDBI Bank cut its base rate after the RBI announcement, and the head of India’s top lender, State Bank of India, said banks likely will cut lending rates.
Why does the RBI need to do things like this? The central bank must keep inflation in check while stimulating growth. This is important to India, whose growth rate in recent years has slowed. That has led to questions about the country’s prosperity, the future of its swelling ranks of middle-class citizens, and the possibility that years of economic success for the country and millions of its inhabitants might not last.
Avoiding higher inflation also is important. Data released earlier this month suggests that inflation is at a three-year low, which makes it easier for the RBI to cut rates. Still, there is a fear it could rise again, especially after a rise in diesel prices. Other concerns include fiscal deficit and current account deficit. That’s the reason that the RBI hinted further rate cuts would be conditional on the government’s moves to control fiscal deficit. Hence, the RBI remains cautious about rate cuts going ahead. The Sensex fell more than 100 points on Tuesday because of this.
The next development to watch out for is the release of the annual budget on Feb. 28. As Andy Mukherjee notes at Reuters Breakingviews:
“Finance minister P. Chidambaram has promised fiscal consolidation and other reforms. If he avoids the temptation to indulge instead in vote-buying populist measures that increase the government’s spending commitments, there may be hope not just of another rate cut, but of a recovery too.”
(You can follow Aditya on Twitter @adityayk)