THE RESERVE BANK OF INDIA'S REPO RATE CUT - ECONOMY

The Reserve Bank of India's Repo Rate Cut - economy

NEWS: The Reserve Bank of India (RBI) has made a significant move in its monetary policy by reducing the repo rate by 25 basis points (bps), bringing it down to 6.25%.

 

WHAT’S IN THE NEWS?

This marks the first repo rate cut in nearly five years and is aimed at stimulating economic growth by making borrowing more affordable. Lower borrowing costs are expected to encourage increased consumer spending and business investments, ultimately boosting economic activity.

 

What is the Repo Rate and Why Was it Reduced?

Definition of Repo Rate

  • The repo rate, short for “Repurchase Option”, is the interest rate at which the Reserve Bank of India (RBI) lends money to commercial banks in exchange for government securities.
  • This lending is usually short-term, helping commercial banks meet their temporary liquidity needs.
  • Under this arrangement, banks agree to repurchase the securities from the RBI at a later date, typically at a slightly higher price, which accounts for the interest charged by the RBI.

 

Impact of Changes in the Repo Rate

  • Increase in the Repo Rate:
    • If the RBI increases the repo rate, borrowing from the central bank becomes more expensive for commercial banks.
    • This discourages banks from borrowing funds, reducing the overall liquidity in the economy and making loans more expensive for businesses and consumers.
    • As a result, demand for goods and services may decline, helping to control inflation.
    • This type of policy is known as contractionary monetary policy because it restricts money supply and economic expansion.
  • Decrease in the Repo Rate:
    • A decrease in the repo rate makes it cheaper for banks to borrow money from the RBI.
    • Banks, in turn, lower their lending rates for consumers and businesses, making loans more affordable.
    • This increases liquidity in the market, boosting economic activity by encouraging more borrowing and spending.
    • This is known as expansionary monetary policy, as it promotes economic growth by injecting liquidity into the system.

 

Reason for the Repo Rate Cut

  • The RBI has reduced the repo rate to stimulate economic activity by making credit cheaper and more accessible.
  • Lower borrowing costs encourage individuals to spend more on consumer goods, real estate, and automobiles, while businesses can invest more in expansion and production.
  • The ultimate goal is to boost economic growth while maintaining inflation within a manageable range.

 

Inflation and Growth Outlook

  • Inflation Management:

·         Inflation in India is currently within the RBI’s target range of 4%.

·         With inflation under control, the RBI has room to reduce interest rates without the immediate risk of excessive price increases.

  • GDP Growth Projections:

·         The GDP growth rate for FY 2025-26 is expected to be 7%, reflecting a positive economic outlook.

·         Retail inflation is forecast to be around 4.2%, suggesting a stable price environment that allows for policy adjustments like the repo rate cut.

 

How Will This Impact the Economy?

Impact on Borrowing Costs

  • A lower repo rate reduces the cost of borrowing for commercial banks, enabling them to offer loans at lower interest rates to businesses and consumers.
  • EMIs (Equated Monthly Installments) on home loans, auto loans, and personal loans are expected to decline, making debt repayment easier for individuals.
  • Banks will also reduce lending rates linked to external benchmarks, such as the Marginal Cost of Funds-Based Lending Rate (MCLR) and repo-linked loans, further benefiting borrowers.

 

Increased Accessibility to Credit

  • With borrowing costs lower, businesses will find it easier to take loans for expansion, hiring, and capital investment.
  • Consumers will find it more affordable to finance purchases, leading to increased spending on goods and services.
  • This rise in borrowing and spending should accelerate economic activity, promoting job creation and industrial growth.

 

Alignment with Global Economic Trends

  • Many central banks around the world have adopted accommodative monetary policies, cutting interest rates to support economic recovery.
  • The RBI’s decision to lower the repo rate aligns India’s monetary policy with global trends, ensuring that the country remains competitive in attracting investments.

 

Potential Risks of the Repo Rate Cut

While the repo rate cut has several positive effects, it also carries certain risks:

  1. Higher Inflation:

·         Lower interest rates increase the money supply, which can raise demand for goods and services.

·         If supply does not keep pace with demand, inflation may rise, making essential goods and services more expensive.

·         Although inflation is currently within target, sustained demand growth could put upward pressure on prices.

  1. Lower Returns on Savings and Fixed Deposits:

·         A decrease in interest rates on loans often leads to a reduction in interest rates on savings accounts and fixed deposits.

·         This makes saving less attractive, potentially discouraging individuals from setting aside money in banks.

·         Retired individuals and others dependent on fixed-income investments may see their earnings decline, impacting their purchasing power.

 

Projections for GDP Growth and Inflation

  • GDP Growth Expectations:

·         The Indian economy is projected to grow at 4% in FY 2024-25, reflecting a slight slowdown from the 8.2% growth rate recorded in the previous year.

·         However, for FY 2025-26, growth is expected to rise to 6.7%, supported by increased investment and economic activity.

  • Inflation Forecast:

·         Retail inflation is projected to be 2% in FY 2025-26, with factors such as falling vegetable prices and declining global edible oil prices contributing to lower overall inflation.

·         Despite this, there are concerns about inflation sustainability, especially if demand surges due to easy credit availability.

  • Rupee Depreciation Concerns:

·         The Indian rupee has weakened, reaching 87 against the US dollar.

·         A weaker currency makes imports more expensive, which could increase inflationary pressures, particularly for fuel and essential commodities.

 

Conclusion

  • The RBI’s decision to cut the repo rate by 25 bps to 6.25% is a strategic move aimed at stimulating economic growth by making credit cheaper.
  • While this will encourage borrowing, investment, and consumer spending, it also presents risks such as inflationary pressures and reduced savings returns.
  • With inflation currently within the RBI’s comfort zone, the central bank sees an opportunity to support growth without significantly raising inflation risks.
  • Going forward, careful monetary policy management will be essential to balance economic expansion with price stability, ensuring long-term sustainable growth.

 

Key Interest Rates in India’s Monetary Policy

The RBI uses several key interest rates and reserve requirements to regulate liquidity and control the flow of money in the economy.

1. Repo Rate

  • The repo rate is the interest rate at which the RBI lends short-term funds to commercial banks, with an agreement that the banks will repurchase the securities at a later date.
  • A higher repo rate discourages borrowing, reducing money supply and controlling inflation.
  • A lower repo rate encourages borrowing, increasing liquidity and promoting economic growth.

2. Reverse Repo Rate

  • The reverse repo rate is the interest rate the RBI pays to commercial banks when they deposit their excess funds with the central bank.
  • A higher reverse repo rate incentivizes banks to park more money with the RBI, reducing liquidity in the market.
  • A lower reverse repo rate encourages banks to lend more money to businesses and consumers, boosting economic activity.

3. Bank Rate

  • The bank rate is the interest rate charged by the RBI when it lends long-term funds to commercial banks.
  • It influences lending rates in the economy. A higher bank rate increases borrowing costs, while a lower bank rate makes borrowing cheaper.

4. Statutory Liquidity Ratio (SLR)

  • The Statutory Liquidity Ratio (SLR) refers to the percentage of a commercial bank’s net demand and time liabilities (NDTL) that must be held in the form of liquid assets such as cash, gold, or government-approved securities.
  • The RBI mandates this reserve to ensure banks remain financially stable and have sufficient liquidity to meet obligations.
  • Increasing the SLR reduces the funds available for lending, tightening liquidity and controlling inflation. Lowering the SLR frees up funds, boosting lending and economic activity.

5. Cash Reserve Ratio (CRR)

  • The Cash Reserve Ratio (CRR) is the percentage of a commercial bank’s total deposits that must be kept as reserves with the RBI in the form of liquid cash.
  • CRR is used by the RBI to regulate liquidity in the banking system.
  • A higher CRR means banks have less money to lend, reducing liquidity in the economy.
  • A lower CRR allows banks to lend more, increasing money supply and stimulating growth.

6. Marginal Standing Facility (MSF) Rate

  • The Marginal Standing Facility (MSF) rate is the interest rate at which banks can borrow money overnight from the RBI in emergency situations when they have exhausted their borrowing options under the repo rate facility.
  • MSF provides a last-resort liquidity support to banks facing short-term shortages.
  • A higher MSF rate discourages emergency borrowing, while a lower MSF rate provides easier access to funds.

The RBI’s monetary policy plays a critical role in regulating inflation, stabilizing the financial system, and promoting economic growth. By adjusting interest rates and reserve requirements, the RBI ensures that liquidity in the economy remains balanced.

  • Expansionary monetary policy boosts growth by making borrowing cheaper, increasing spending and investment.
  • Contractionary monetary policy controls inflation by making borrowing expensive, reducing excess money supply.

Key interest rates such as repo rate, reverse repo rate, and bank rate, along with reserve requirements like SLR and CRR, serve as important tools for maintaining financial stability. The RBI continuously monitors economic conditions and adjusts its policies accordingly to ensure sustainable growth while keeping inflation under control.

 

Source: https://www.thehindu.com/business/Economy/rbi-monetary-policy-committee-meeting-friday/article69190903.ece