Young Investor

De-coding credit policy terms

Rajalakshmi Sivam | Updated on February 05, 2011 Published on January 30, 2011


A look at the RBI's tools to help curb liquidity in the market.

“Last month I spent Rs 500 extra on vegetables. Onion and tomato alone ate into my movie budget,” cried Sonu, a young man who works with an animation company. Rise in the prices of vegetables, cereals, milk and oil have been making headlines in newspapers for the last many months.

The headline inflation for December rose to 8.43 per cent. With this, the RBI and the government rolled up their sleeves to fight inflation. After all, how long can anyone ignore the common man? In its policy meet last week, the RBI increased the repo and reverse repo rates by 25 basis points each, after leaving them unchanged in the mid-quarter review in December.

Prices soar because of two reasons — one, supply shortage (following logistic problems and sometimes severe rain/drought) and, two, increase in money supply (when money supply increases, consumption demand soars). In times such as the present, when little can be done to resolve supply-side issues, the RBI takes monetary tools to battle inflation. Recently, with growth in credit offtake (outpacing deposit growth), the case for monetary tightening by the RBI has become stronger. We explain below the RBI's tools that help curb liquidity (money supply) in the market.

Repo rate

Similar to the way we borrow from banks, the banks borrow funds from the central bank, the RBI. The rate at which the RBI lends to banks is called the repo rate. In the recent policy meet, the RBI increased the repo rate to 6.5 per cent from the earlier 6.25 per cent. While this will eventually translate to higher borrowing rate for you and me, it will also deter banks from borrowing from the RBI to an extent and, thereby, reduce money flow into the market.

Reverse repo rate

Reverse repo is the rate at which banks get paid for parking their surplus funds with the RBI. This rate has been hiked to 5.5 per cent from 5.25 per cent initially (was as low as 3.5 per cent in April 2009). It is an indirect incentive to banks to deposit money with the RBI.

Cash Reserve Ratio (CRR)

The proportion of total deposits that banks park with the RBI is called the cash reserve ratio. Last January, when there was concern over the rising inflationary trend, the RBI increased CRR sharply by 75 basis points to rein in money supply in the market. This time, however, CRR has been left untouched at 6 per cent.

Statutory Liquidity Ratio (SLR)

SLR is the proportion of total deposits that banks invest in approved government securities. Despite request from bankers to reduce the SLR in the pre-policy meet, the RBI kept this rate unchanged at 24 per cent this time.

Market Stabilisation Scheme (MSS)

At times, when there is a significant increase of money flow (say, because of the RBI's dollar purchase in the market to strengthen rupee) in the country, the RBI issues treasury bills and government securities to suck liquidity and this is what is termed Market Stabilisation Scheme. The RBI may also resort to buying back the above securities when there is liquidity constraint.

Interest income/expense

All these measures of monetary tightening end with the consumer. When the RBI increased the CRR and repo rates in June 2008 by 50 basis points each, within a week's time, the banks came out with a 50-75 basis points increase in lending rates. This time again such a reaction is expected.

Mr Paresh Sukthankar, Executive Director, HDFC Bank, said in a conference call last week that ‘‘there will be an increase in lending rates, both in retail and corporate sides''. He said that he expected most retail products, including auto loans, to increase in the next few days. Home loan EMIs, monthly instalments on car and personal loans, therefore, can be expected to rise, going ahead.

Fixed deposit investors can, however, cheer. When cost of funds increase, banks increase the deposit rates too. If you are looking for a FD product, waiting for some time may give you more attractive rates. As banks are looking to mobilise deposits, it looks like deposit rates may be the first to go up before lending rates increase.

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Published on January 30, 2011
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