Understanding the impact of RBI policy rates

Borrowers need to calibrate their loan repayment strategy to lessen the debt burden
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Over a period of time, fast financial intermediation even into the unreached areas of domestic affairs of a common man has changed the economics of thinking preferences of one and all.

In this major shift in thinking process, it is now common among people to keenly follow the stance of monetary policy whenever the Reserve Bank of India (RBI) announces it.

It is interesting to note that people today know more about percentages of cash reserve ratio (CRR), Repo & Reverse Repo rates than the prices of essential commodities.

Let me tell you this fast financial intermediation through loan products for almost all population segments has changed, rather I would say hostaged their lives to the culture of equated monthly installments (EMIs).

In other words, these EMIs have become an integral part of most households. However, one thing is sure - these EMIs have now assumed the status of being a stimulator and not a stigma anymore.

Actually, there is a situation loaded with uncontrolled rising food prices, higher cost of goods and services and woes of inflation that we have been grappling with on a daily basis. while anticipating the fear of inflation primarily due to the price shock from vegetables, the Reserve Bank of India (RBI) announced after the conclusion of its monetary policy committee (MPC) meeting held on August 10 that banks will be required to maintain a 10 per cent incremental cash reserve ratio (ICRR) from August 12. It also kept the main policy instrument – the repo rate – unchanged at 6.50 per cent.

This is the third repo rate pause implemented by the RBI. Notably, over the past 15 months, we witnessed a series of rate hikes owing to the increase in the repo rate by 250 basis points.

Even as the continued pause in repo rate has kept the interest rates on loans under control with no upward swing, asking the banks to park 10 per cent of their deposits as incremental cash reserve ratio on a temporary basis may force some banks to hike interest on loans. However, there is no increase in the CRR requirement for banks, which is currently at 4.5 per cent.

Since, the Reserve Bank of India’s Monetary Policy Committee (MPC) has revised Q2 (July-September) inflation forecast higher by 100 basis points to 6.2%, and FY24 inflation projection to 5.4% from 5.1% earlier, there is every possibility of a hike in interest rates on loans in future.

RBI governor Shaktikanta Das has reiterated that the central bank remains “firmly focused on aligning inflation to the target of 4%”. He also said that RBI will look through “idiosyncratic shocks” on food inflation, but “if such idiosyncrasies show signs of persistence, we have to act”.

What is the cash reserve ratio and why is it mandatory for banks?

Cash reserve ratio (CRR) is the percentage of total deposits that banks are required to keep in reserves either in the vaults or with RBI so that the same can be used for bank’s customers if the need arises. In other words, when there is sudden demand for liquidity, the banks should have enough cash to meet this demand. Precisely, CRR ensures liquidity to make the repayments. It has a direct or indirect effect on everyday financial transactions. It has ripple effects on interest rates on loans as well as deposits, equity and commodity markets, imports and exports, foreign exchange, real estate market, and even the Gross Domestic Product (GDP).

Banks do not get any interest on this money. So, it is one of the major weapons in RBI’s arsenal that allows it to maintain a desired level of inflation, control money supply and liquidity in the economy.

When there is a hike in CRR, it reduces the cash with the banks and consequently impacts the total cash flow in the economy. In the end, a hike in CRR controls prices and inflation.

A cut in CRR will result in more cash in the system and enable the banks to lend more to businesses to boost economic activity and growth.

Precisely, CRR is a policy tool in the hands of RBI to strike a balance and growth of economy.

What exactly is incremental cash reserve ratio (ICRR)?

Incremental cash reserve ratio (ICRR) is a policy tool to drain excess liquidity from the banking system. According to the RBI, the reason to ask banks for an incremental cash reserve ratio of 10 percent on a temporary basis is due to its withdrawal of Rs 2,000 notes. In May this year, the apex bank had announced withdrawal of these notes from circulation and gave people the option to either deposit the currency in banks or exchange the notes. On August 1, the apex bank had announced that 88 per cent of Rs 2,000 banknotes had returned to the banking system.

So,this is just a measure to manage the temporary upsurge in system liquidity as the move, according to the experts, would drain out liquidity close to Rs 70,000–75,000.

What will happen to interest rates on deposits and loans when the repo rate stands unchanged?

As the RBI has kept the policy rate unchanged in the August policy, all external benchmark lending rates (EBLR) linked to the repo rate will not rise. There will also be no increase in fixed deposit rates. Experts believe that to hold or not to hold deposit rates at the current levels will depend on the surplus liquidity in the banking system.

What should borrowers do when there is change in repo rate?

See. In the given situation when inflation, especially food inflation remains a worry, the pause, third in series, in key policy rate - repo rate - is again a relief to the borrowers. The home loan borrowers whose interest rate is linked to the repo rate are the most benefited ones. However, for future the borrowers need to do an extra bit as.repaying the loans as per the given repayment schedule won’t help to reduce the debt burden. They need to calibrate their repayment strategy. For instance, experts are of the view that in the given scenario a borrower should look at prepaying 5% of the loan balance each year or get it refinanced at a lower rate. This would help in lowering interest outgo and tenure. In the case of refinancing, the borrower needs to calculate the net savings after moving to a lower rate.

As far as interest rate options are concerned, the banks offer fixed rate options and floating rate options. Some banks offer a mix of both options. Here they initially charge a fixed rate of interest for two or three years and then apply a floating rate option. In a way, the fixed rate option is not always fixed. Banks can unilaterally change fixed rate to floating rate option. However, in the current market scenario,the floating rate option seems better.

Usually when interest rates on loan, for instance home loan, goes up during the currency of the loan, the EMI also goes up and shocks the borrower. Here banks have an option with them to not burden the borrower with higher EMI by extending the loan repayment schedule. There have been incidents when banks extended the repayment schedule without informing the borrower. so, it is imperative for the borrower to check the repayment schedule as per the loan agreement. notably, an elongated repayment schedule means more interest payout.

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