The Hindu Business Line : Taming inflation

The RBI’s decision to hike the cash reserve ratio (CRR) and the repo rate by 50 basis points has dominated the headlines this week. Some say the hikes were necessary, at a time when inflation is touching a 13-year high. Controlling inflation is priority for the government, with elections round the corner. But the hike has not gone well with the stock market. Every time the RBI hikes the CRR, repo rate or both, the markets turn south.

Controlling inflation is not easy for the Government. It has taken measures such as the ban on futures trading and export restrictions on key commodities, implementing the Market Stabilisation Scheme and monetary tightening to cool down prices and money supply. But the depreciating rupee and the global rise of crude oil and other commodity prices have only worsened the situation.

Control measures

The RBI, being the central bank and the regulator, looks after demand and supply of the rupee. As the economy grows, more liquidity circulates in the system, leading to increase in inflation. The RBI, to control inflation, uses tools such as CRR, repo rate, reverse repo rate and MSS.

Cash reserve ratio (CRR): This is the amount of cash the bank is required to park with the RBI. Generally calculated as proportion of total deposits, CRR has now been increased to 8.75 per cent, effective July 19.

The hike will suck out Rs 19,000 crore from the system, reducing the amount available for lending. This is bad news for corporate capex plans and the market reacts negatively.

Banking stocks, in particular, take a beating. This is because the cash held with the RBI does not yield any income. Moreover, as a higher CRR sucks out the amount available for lending, banks have to attract more deposits and, this, at a higher cost.

Banks will have to either hike its lending rate to compensate for the higher borrowing cost or compromise its net interest margins (NIMs). Higher the lending rate, greater the risk of default by the borrower. This is why markets downgrade banking stocks.

Repo Rate: This is the rate at which the banks borrow short-term funds from the RBI. The repo rate is not frequently used by banks with high proportion of liquidity. Banks prefer traditional borrowing to borrowing from the RBI or other banks, but as the liquidity in the system gets scarce, banks look at other options. As the repo rate is hiked, other short-term lending rates also tend to rise. Banks, too, follow suit and hike lending rates.

Existing and the new borrowers have to pay higher interest for the amount borrowed. This could slow down the credit-offtake to the banks.

Investment options

Banks are planning to increase deposit rates. This is good news for the investors looking out for alternative investment avenues to the stock market. With the expectation that the stock market might not perform so well this year, the risk-averse investors get 9.5-10 per cent risk-free interest rate on term deposits.

While markets have digested the recent rate hikes, analysts are expecting another round of rate hikes as the inflation is not expected to reverse in the near future. This has dented investor expectations on earnings growth and returns from the stock market. As a result, markets remain volatile.

More Stories on : CRR & Bank Rates | Economy | Young Investor | RBI & Other Central Banks

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page