Fintotal News Analysis | Understanding Recent RBI Action and Its Implication
Understanding Recent RBI Action and Its Implication
Kripananda Chidambaram, 31 Jan 2013

Couple of days back RBI cut the repo rate from 8% to 7.75% and cash reserve ratio to 4% from 4.25%. This made headlines. Many from the non-finance background are quite puzzled about its implication on their personal finance, though indistinctly they hope that their EMI might go down.

Lets us try and understand how the RBI rate manipulation affects us directly.

Dynamics of money

Money is basically known as currency and the word is derived from the word current (flow).  The nature of money is circulation, flowing from one hand to the other.  When we buy something our money flows out and at the other end for the seller the money flows in. This exchange of money happens billions of time in a day in a country.

Every time money changes hands some value also gets exchanged. Meaning needs and wants are met, profits are made, salaries are paid, assets are created, taxes are collected, etc. This cycle keeps going on and on.

So more the number of times money changes hands more value is created at the stakeholder level. For example if you spend once a day then one set of people is getting benefited. If you spend money say twice in that day then two sets of people are getting benefited and thrice in that day then 3 set of people are getting benefited and so on. More money getting exchanged is better at the economy level.

From this observation we can easily conclude that money flowing furiously creates a good economy with large beneficiaries.  But there is a flip side to this. High money flow ends up increasing the prices of goods and services. This happens primarily because more money is chasing fewer goods.  This is what is known as inflation.

The irony is more money flowing through hands means better economy and better incomes for people but that also leads to increase in prices of products and services.

We are drawing to the point that flow of money in the economy determines broadly two things: Growth of the economy and Inflation. So if one wants to manipulate growth or inflation, they can be managed by controlling the flow of money. If you want to encourage growth then let money flow well or want to bring down prices squeeze the money flow. So simple, isn't it?

But the question is how does one controls the flow of money. Can government practically tell every citizen to spend less or more? To control the flow of water from our tank to our washbasin we have the tap, so what is the tap to control flow of money?

If you notice the exchange of money between individuals and groups ultimately originates or lands up at the bank. Reasonably we can conclude that bank is the tap that can be used to control the flow of money.  And RBI being the regulator of banks has certain control on these taps.

And how is this executed by RBI? RBI broadly uses repo rate and cash reserve ratio to control the money flow in the economy. Let us briefly understand these measures:

Repo rate

Bank many a times borrows money from RBI to service its needs. RBI charges interest rate on them and that is called as Repo rate. Higher the repo rate higher will be bank benchmark interest rates. Which means when you place deposits with your bank the interest rate will be high and similarly if you borrow money from the bank the interest rate will be higher. 

Cash Reserve Ratio

Simply put, banks are asked to keep a certain percentage of their clients' deposits with RBI. That portion of money is locked and is not allowed to flow in the economy. Higher the cash reserve ratio, lesser the money flow in the economy and lower the cash reserve ratio better the money flow in the economy. 

Let us now understand the recent RBI action; it cut repo rate from 8% to 7.75% and cash reserve ratio to 4% from 4.25%. RBI had to deal with two major challenges- boost growth as well as bring down inflation. The irony is that the relationship between growth and inflation is direct. Hence RBI was cautious all these months and did not do any changes to the repo rate and CRR. But now RBI feels inflation has gone down a bit and the need to prop up the growth is high and therefore the repo rate and CRR cut. 

How will these actions impact you?

Cut in repo rate will translate to lower interest rate on your bank deposits and lower interest rate on your loans. Bringing CRR to 4% from 4.25% literally means 0.25% of the banks' money lying with RBI is free to flow. This actually translates to Rs 18000 crores of free money available with banks. To get the money to flow, banks will encourage people to borrow more by bringing the interest rate down on loans. 

If you are planning to borrow money: then yes it is good news

Already paying EMI: your bank will bring down the interest rate on existing loans, else you can move to a new bank 

If you are a typical FD investor: The interest rate is likely to go down, so better lock in at current rates before you bank starts dropping the rates.