Interesting interest (repo) rate cuts?

Updated: Nov 22, 2019

Recently the repo rate has been set to 5.40% and reverse repo rate at 5.15%

Repo rates are the interest rates at which all the state banks and private banks can borrow money from the RBI. Repo rates is one of the most important ways through which commercials banks can borrow other than taking deposits from the customers. Currently the policy repo rate is 5.40%.

What is reverse repo rate? Reverse repo rate is the rate at which commercial banks make deposits with the RBI. Currently the reverse repo rate is 5.15%. When the repo rates are reduced, the reverse repo rates are also simultaneously reduced.

In February 2019, the Reserve bank of India cut repo rate for the first time in the year by 25 basis points from 6.50% as the economy slowed down. Again, in June, there was another cut by 25 basis points, bring down the repo rate to 6.00%. In June, the monetary policy committee comprised of 6 members, voted in the ratio 4:2 in favor of cutting down repo rates while maintaining a neutral stance of the monetary policy. In their opinion, this was to endure that there is liquidity for banks to overcome short term liquidity mismatch. RBI Governor Shaktikanta Das said that “Global growth is slowing down, Domestic GDP growth is also estimated to slow in 2018-19, with high frequency indicators suggesting slackening of urban and rural demand as well as investment activity,”

“Global growth is slowing down, Domestic GDP growth is also estimated to slow in 2018-19, with high frequency indicators suggesting slackening of urban and rural demand as well as investment activity.”

On 6th of June, the repo rates were dropped by another 25 basis points for the third time in the year owing the slow down. And finally, on 7th of August 2019, the repo rate was further brought down by another 35 basis points with the final repo rate currently being 5.40%. The reverse repo rate also has been brought down to 5.15%.

What is the reason behind subsequent rate cuts?

There is an economic slowdown currently that is impacting all the industries across the country. All the sectors have been taking a hit. The growth rate for GDP had also been decreased from 7.0% to 6.8%. With the domestic demand slowing down and with the investment activity losing traction. The sales in the automobile industry have decreased by 31% compared to the previous year.

This slowdown is a result of the credit unavailability in the country. The non-banking financial companies (NBFCs) are facing a liquidity crunch because of the asset-liability mismatch. This came into light with IL&FS defaulting on its payments in September 2018 with a massive increase in their borrowing costs. There is a dip in the confidence for NBFCs in the markets, it has made the banks and investors cautious alike. Yet there has been an increase in the total borrowings from banks to the NBFCs from 23.6% in March 2018 to 29.2% in March 2019. The banks are trying to compensate for the reduced market access for the sector in wake of the crisis. This liquidity crunch has been spreading far and wide across the sector. With decrease in cash in the system, the banks cut down on the repo rates starting in the year 2019 in the month of February.

The RBI and the government are keen on not letting this affect all sectors, hence repo rates are being reduced to increase cash flow in the economy and push consumer demand in the country. The industrial growth measured by index of industrial production has gone down. The global tensions have impacted India’s exports and investment activities. There is a dire need for revival of the economy in India.

The RBI joins global central banks in reducing the cost of funds to beat an economic slowdown partly induced by trade wars and slowing demand in domestic economies. The US Federal Reserve reduced rates by a quarter point recently, but dampened expectations by highlighting that this was more a mid-cycle adjustment rather than the beginning of a lower-rate cycle. The central banks of countries such as Thailand and New Zealand have also cut interest rates.

The repo rate cut will reduce the current cost of loans, EMIs and make new loan cheaper, which will boost aggregate expenditure. On the flip side, a reduction in repo rates also means that the interest earned on fixed income returns will also be lowered as evidenced by the State Bank of India (SBI) reducing interest rates on fixed deposits (FD). The interest rate cut has been sharper for short-term tenures, i.e., up to 179 days by 50-75 bps. However, for longer tenures the bank cut rates by 20 bps.

To understand how it helps an existing borrower let us take an example of a loan of INR 30,00,000. (If the bank transfers the benefit to the customer)

What are the possible reasons that the economy is not performing well?

Monetary Transmission system - Numerous experts have pointed out a significant lag in monetary transmission system. It means that the repo rate cuts done by the RBI to increase the money supply in the economy by easing availability of credit is not having its intended effect increasing economic activity. The benefit is not being passed on to the borrowers by the banks. Banks are already facing a lot of stress on their balance sheet due to NPAs and they use these repo rate cuts to improve their operational efficiencies and it helps them in increasing their margins.

This becomes problematic as the intention behind the repo rate cuts is to increase liquidity in the market by increase in credit availability at a lower cost which will be used to drive economic activities and stop the economic slowdown.

Addressing this issue, Finance minister, Nirmala Sitharaman, said in a press briefing that banks should be more reasonable in passing on interest rate cuts to the end customer, i.e., the borrower. She said that it has been a common grievance across segments that benefit of the various rate cuts by the Reserve Bank of India is not reaching the customer, and even if it does "it trickles down over months and years. PSBs are reducing their MCLRs while others like SBI and Union Bank have provided new products like repo-rate linked vehicle loan and repo-rate linked home loan. More products like this can be expected in the future as the Finance Ministry and RBI both are keen on boosting the economy and improving the transmission system of policy changes.

Banks and NBFCs are extremely cautious in their lending to different sectors and are limiting their exposures to certain high-risk sector. This directly impacts the credit available to the sector and banks will continue to lend to good quality businesses and the RBI’s measures are unlikely to induce them to take on riskier assets. The growing concern of unresolved liquidity issue with many NBFCs, will likely persist.

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