The Reserve Bank of India increased the repo rate to 5.40 per cent under the liquidity adjustment facility (LAF) on August 5. The Monetary Policy Committee (MPC) took this decision based on the evolving macroeconomic situation in the country. Repo rate, which is the rate at which the RBI lends money to commercial banks, is now higher than the pre-Covid level of 5.15 per cent.

The repo rate was slashed during the pandemic to help revive the economy. However, inflation in recent months has become a cause of concern for the RBI. The inflation forecast by the RBI for FY23 is 6.7 per cent. CPI inflation has remained above the upper band of 6 per cent for six consecutive months, though there has been some easing of food and fuel prices. But due to the uncertain international situation, energy prices are still volatile.

Borrowing costs

There will be both short- and long-run consequences of this rate hike on the economy. The immediate impact will be an increase in interest rates and hence a decrease in the money supply in the economy. Any increase in the repo rate, raises the cost of borrowing for banks.

Banks pass this on to customers by hiking the interest rate on loans; deposit rates also go up as a result.

Fixed income securities become lucrative when the repo rate goes up. However, this depends on the liquidity available with the banks and how much of the interest rate burden banks pass on to their customers. And this will result in higher EMIs for new home, auto, and other consumer durable loans and also an extension of tenures for existing floating rate loans. Any such cumulative burden will hit the middle-class hard.

In the long run, the borrowing rates for corporates will go up, which will result in companies, especially in the manufacturing sector, cutting down on expansion plans. Close to 60 per cent of India’s GDP comes from consumption. The pandemic resulted in job loss and salary cuts, which adversely affected consumption. The unemployment rate is now 6.62 per cent.

Infrastructure had become the ‘Achilles heel’ for the manufacturing sector and the economy. But now, with increased interest rates, capital-intensive sectors like real estate and infrastructure will be further affected due to increased project costs. This will hamper the revival of the economy, which has been showing signs of recovery.

MSMEs will be hit

The government had been trying to revive the MSME sector and made a lot of efforts in this year’s Budget — including liquidity infusion, bank guarantees, and public procurement through MSMEs. But most MSMEs struggle to get affordable credit from lending agencies due to bottlenecks in the regulatory structures. Now the increased cost of borrowing is bound to hit the sector’s growth and competitiveness.

The increased rates will also hit the asset quality of the banking sector. Though the gross non-performing assets (GNPA) ratio had gone down to 5.9 per cent in March, with the escalated cost of borrowing, the GNPA level may not go down further. The RBI has targeted a bad loan ratio of 5.3 per cent for March 2023, which seems difficult to achieve now.

High priced credit hampers the modernisation and expansion of industries and hence employment generation.

While the RBI has to take steps to control inflation, corrective measures must be taken to ease the burden of high interest rates on the industry through other policy measures.

Verma is Deputy Director, CSDC, Seacom Group of Institutions, Kolkata, and Gupta is Associate Professor (Economics), BML Munjal University, Gurugram

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