EFFECTS OF REPO RATE ON INDIAN ECONOMY

PRESENTATION BY ANIRUDH DAGAROLL NO :- 274ST.Xavier’s College

OBJECTIVES OF STUDY:- To understand RBI`s Function and role played by it in the Indian Economy

To understand the Concept of Repo Rate and Reverse Repo.

To elaborate the use of Repo Rate by RBI for control purpose

To establish relationship between Repo rate and :-

Inflation & Interest Rates

GDP Growth

Foreign Exchange Price

Fiscal Deficit

To study how effectively Repo Rate has been used in Indian Economy. 

RESEARCH METHODOLOGY

Method of data collection:-Secondary sources:-The data for study has been collected from various sources: Books Journals Internet sources Statistical Tools Used: Simple tools like bar graphs, tabulation, line diagrams have been

used.

1.INTRODUCTION

The Reserve Bank of India (RBI) is India's central banking institution, which controls the monetary policy of the Indian rupee. It was established on 1 April 1935 during the British Raj in accordance with the provisions of the Reserve Bank of India Act, 1934. The share capital was divided into shares of 100 ₹each fully paid which was entirely owned by private shareholders in the beginning. Following India's independence in 1947, the RBI was nationalized in the year 1949.

1.1 FUNCTIONS OF RBI :- Monetary Authority Regulator and supervisor of the financial system Manager of Foreign Exchange Issuer of currency Developmental role Related Functions

1.1.1 CONTROLLER OF CURRENCY

CONTROLLER OF CURRENCY

ISSUES CURRENCY NOTES.

CHECKS FAKE CURRENCY AND

ENSURE THAT IT IS NOT

REDISTRIBUTED.

IS THE OWNER OF CURRENCY CHEST

1.1.2 BANKERS BANK

BANKERS BANK

REGULATES AND ENSURES STABILITY.

CONTROLS VOLUMES OF

THEIR RESERVES (SLRs and CRRs).

EXTENDS CREDIT FACILITIES TO

BANKS.

1.1.3 LENDER OF THE LAST RESORT

LENDER OF THE LAST RESORT

RAISE DEPOSITS AND BORROW MONEY TO

MEET COMMITMENTS.

BORROWING AGAINST GOVERNMENT SECURITIES.

MERGING WEAK BANK WITH STRONG BANKS

TO ENSURE LONG TERM GROWTH.

1.1.4 BANKERS TO GOVERNMENT

BANKERS TO GOVERNMENT

MANTAINS ACCOUNTS OF

VARIOUS MINISTRIES.

ISSUER OF SECURITIES.

SHORT TERM CREDIT TO

GOVERNMENT.

1.1.5 SUPERVISING AUTHORITY/REGULATOR AND SUPERVISOR

SUPERVISING AUTHORITY/REGULATOR

AND SUPERVISOR

ADVICES GOVERNMENT FOR

SALE AND PURCHASE OF SECURITIES.

REGULATES THE BANKS AND NBFCs IN

INDIA.

ADVICES GOVT. ON HOW MUCH INTEREST IS TO BE

ALLOWED ON SHORT/LONG TERM CREDIT.

1.2 MONETARY POLICYA Tool used to influence Interest rates, Inflation and credit availability through changes in supply of money available in the economy .1.2.1 Expansionary policyExpansionary policy increases the total supply of money in the economy used to combat unemployment in a recession by lowering interest rates, 1.2.2 Contractionary policyContractionary policy decreases the total money supply involves raising interest rates in order to combat inflation increasing interest rates slows the economy by making funds more expensive to firms, and promotes consumer savings which decreases revenues by firms.

1.3 Different rates in monetary policy used by RBI :-

1.3.1 Bank Rate :-1.3.2 Call Rate :-1.3.3 CRR :-1.3.4 SLR :-1.3.5 Repo (Repurchase) Rate

Repo rate is the rate at which banks borrow funds from the RBI to meet the gap between the demand they are facing for money (loans) and how much they have on hand to lend.

1.3.6 Reverse Repo Rate :-The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate. The RBI uses this tool when it feels there is too much money floating in the banking system.

2.1 Liquidity adjustment facility (LAF)

Liquidity adjustment facility is a monetary policy tool which allows banks to borrow money through repurchase agreements. LAF is used to aid banks in adjusting the day to day mismatches in liquidity. LAF consists of repo and reverse repo operations. Repo or repurchase option is a collaterised lending i.e. banks borrow money from Reserve bank of India to meet short term needs by selling securities to RBI with an agreement to repurchase the same at predetermined rate and date. The rate charged by RBI for this transaction is called the repo rate. Repo operations therefore inject liquidity into the system. Reverse repo operation is when RBI borrows money from banks by lending securities. The interest rate paid by RBI is in this case is called the reverse repo rate. Reverse repo operation therefore absorbs the liquidity in the system

The introduction of Liquidity adjustment facility in India was on the basis of the recommendations of Narsimham committee on banking sector reforms. In April 1999, an interim LAF was introduced to provide a ceiling and the fixed rate repos were continued to provide a floor for money market rates.

2.1.2 BASIC IDEA

2.1.3 What Does Basis points means??

2.1.4 Types of repo rate:- Over night repos Term repos Open repos

2.1.5 Determinants of repo rate :- Credit quality Delivery Collateral Availability Current rates.

The way in which changes in the repo rate affect inflation and the rest of the economy is known as the transmission mechanism. The transmission mechanism is actually not one but several different mechanisms that interact. Some of these have a more or less direct impact on inflation while others take longer to have an effect. It is generally held that a change in the repo rate has its greatest impact on inflation after one to two years.

2.2 Transmission Mechanism :-

Click icon to add picture

2.2.1 Credit Channel:-

If the interest rate rises, banks choose to decrease their lending and instead buy bonds.

Companies find it more difficult to borrow money. Companies that are either unable or unwilling to borrow must cut back their

activities, postpone investment and so on, and this dampens activity in the economy.

2.2.2 Interest Rate Channel :-

When Repo Rate increases. Banks lend from RBI at a higher rates of interest They lend it to the borrowers at a high rate of interest

As lending interest rate increases, borrowing of money decreases.

Banks unable to borrow at repo rate Increase in the deposit interest rate to attract depositors.

2.2.3 Exchange Rate Channel:- When Repo Rate increases. Interest Rate Increases Make Indian assets more attractive than investments denominated in other

currencies Results in a capital inflow and increased demand for Rupees Which strengthens

the Exchange Rate. Fall in exports & increase in imports

Lower Import Prices & Reduction in demand Lower Inflation.

3.Case Study

3.1 Repo Rate Vs. Inflation :-

11 -1210-1109-1008-0907-08 -

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

11.00

12.00

13.00

14.00

9.88

6.00

4.88

7.25 7.25

8.90

11.70

10.90

8.30

6.40 Repo Rate (%) (annual Average)3Inflation

Last 5 year comparison of Repo rate and Inflation

3.2 Repo Rate Vs. Exchange Rate ( Dollar)

2008 2009 2010 2011 2012 -

2.00

4.00

6.00

8.00

10.00

36

38

40

42

44

46

48

50

7.75 7.25

4.88

6.00

7.90

40.2755

46.1515

47.4153

45.6157

48.1317

Repo Rate (Annual Average)6

Yearly Average Ex rate5

Last 5 year comparison of Repo rate and Exchange rate.

3.3 Repo Rate Vs. Gross Domestic Product

2006 2007 2008 2009 2010 2011 2012 -

2.00

4.00

6.00

8.00

10.00

12.00

6.28

7.25 7.75

7.25

4.88

6.00

7.90

9.20 9.00

7.40

7.40

10.40

7.20

8.20

Repo Rate (Annual Average)7GDP6

Last 7 years comparison of Repo rate and GDP

3.4 FII Vs. Inflation

FII stands for Foreign Institutional Investment. Here we want to show how high inflation or inflamatory conditions are unfavourable for FII's and discourage them to invest in such conditions.

Suppose a foreign investor wants to invest in Indian Economy. He has $100000 to invest in Indian market. At the time of investment exchange rate was 50/$. So his gross amount of investment in Indian currency ( INR) is 50 lakhs. During the year he earns Rs100000 as profit which brings his gross investment at the year end to Rs 51 lakhs. This picture is bright from the investor's point of few given the exchange rate remains constant. But due to inflation it turns out that the exchange rate is now 55/$. Now if he wants to withdraw his money from Indian market . Gross amount he will get is $ 92727 which means he incurred a loss of $ 7273 within a year in Indian market. Thus we see the gain in Indian currency is outcast by loss due to foreign currency fluctuation and discouraging FII's to invest in high inflation conditions. The same can be shown with the help of an bar graph

Initial outflow final inflow -

10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000

100,000

Series2Series1

Here series 1 is his money before and after investment and series 2 represents loss suffered by him.

3.5 Repo Rate Vs Fiscal Deficit

Decrease in Repo rate

Increase in money supply in economy

Increase in Demand of goods in economy

Increase in GDP Growth Rate

Increase in the Average income of people and corporate

Increase in Tax Revenue of the government

Decrease in fiscal deficit of the government for the period

Decrease in Repo rate

Decrease in Value of domestic currency

Increase in Exchange Rate

Increase in Export of goods

Increase in inflow of foreign currency

Decrease in Current Account Deficit

2007 2008 2009 2010 2011 2012 -

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

7.25

7.75

7.25

4.88

6.00

7.90

0.50

4.90 5.20

3.80

5.10

5.70

Repo Rate (Annual Average)Fiscal Deficit8

Last 6 years Repo rate comparison with fiscal deficits.

4. Situation case Study

Date - 17th April 2012 , RBI reduces Repo rate by 50 bps.

6.1 BackgroundIndian economy affected by the downturn in growth all over the globe was suffering from macroeconomic problems like high inflation, slow growth rate and high Current Account Deficit. First of all the countries included in “BRICS” to face the downturn in growth was seen as the sign of the coming slow growth period or the end of the much talked about double digit growth expectation. Facing the high inflation problem RBI had raised the lending rate 13 times between March’10 to October 2011 to contain the inflation which was touching double digits. This had led to clamor by industry to cut rates and spur industrial and economic growth that has slowed down considerably during the past few quarters. And with CAD hovering over 4% of GDP , the economy was facing a downgrade in investment ranking risk from many investment ranking institutions.

6.2 Policy adopted

The Reserve Bank of India (RBI) cut interest rates for the first time in three years by an unexpectedly sharp 50 basis points to give a boost to flagging economic growth but warned that there is limited scope for further rate cuts. The RBI cut its policy repo rate to 8%, compared with market and expert expectations for a 25 basis point cut. It also warned that India's current account deficit, which widened to 4.3% of GDP in the December quarter, is "unsustainable" and will be difficult to finance given projections of lower capital flows to emerging markets in 2012.RBI left unchanged the cash reserve ratio (CRR), the share of deposits that banks must hold with the central bank, at 4.75%, in line with expectations, after cutting it by 125 basis points since January to ease tight market liquidity.

Reserve Bank Governor D Subbarao said liquidity conditions are moving towards normal after several months of acute shortage of cash in the banking system, but also said the RBI would take "appropriate and proactive" steps if needed to restore liquidity to comfortable levels.

4.3 Experts view

SIDDHARTHA ROY, ECONOMIC ADVISER, TATA GROUP, MUMBAI :-"The 50 bps point rate cut is most welcome. But going ahead, two things are crucial. First we need more rate cuts to the tune of around 150 bps in order to make the real interest rates realistic. Then, the fiscal side needs to be controlled to prevent crowding out of the private sector and available liquidity is well distributed.“

NITESH RANJAN, CHIEF ECONOMIST, UNION BANK, MUMBAI :-"A very bold step indicating RBI's change in stance. This will help in arresting growth going below the trend level. One can expect the cost of fund and capital going down, which will encourage consumption and investment demand.

"Given the inflationary risks, as mentioned in its (RBI's) macro report, I think the next rate action may wait till first quarter review in July, by when more clear trend on growth and inflation will emerge.“

GAURAV KAPUR, SENIOR ECONOMIST, ROYAL BANK OF SCOTLAND NV, MUMBAI :"I think perhaps another 25 basis points in the first half of this year is likely. I think the room for further cuts is limited. The actual action is to support growth without taking eyes off inflation.

"One comfort factor for the RBI is core inflation, which has fallen below 5 percent, which shows the demand side pressures are easing."

5. FindingsThe summary of the analysis and situation case study can be drawn as follows:-

Repo Rate and inflation are inversely related. That is a decease in Repo Rate leads to increase inflation. Both the economic factor are closely related to each other and Repo rate has a great influence over the inflation rate.

Repo Rate and foreign exchange rate also share a inverse relationship between them. As increase in Repo rate leads to strengthening of domestic currency and thus leading to fall in exchange rate due to strengthening of domestic currency.

Repo Rate and GDP of a country are inversely related. That is if repo rate decreases the GDP of an country increases. This is because of increase in money supply in economy leading to increase in demand of goods in economy. Thus resulting in increase in GDP.

Repo Rate has a positive Relationship with Fiscal Deficit. Though both are not related directly by the relationship is based on two factors which are affected by Repo rate as shown earlier in the analysis part.

Reserve Bank of India (RBI) being the apex bank of the country plays an important role in the economy. As depicted in earlier section it has many functions in the economy ranging from being the banker to the banks to taking decisions regarding monetary policies. RBI uses Repo rate as a tool for controlling money supply in the economy and also to bring the inflation and other factors under control. And the situation case study shows the effectiveness of the policies relating the repo rate and its utilization as a monetary tool for controlling the money supply.

6. Conclusion and limitationRepo Rate which is a very well-known term in our economy plays a vital role in it. From affecting the inflation directly to influencing the foreign exchange rate, repo rate plays a central role in the money supply of an economy. The findings of the analysis done earlier are a proof of how important repo rate is for the economy and how effectively it is used by RBI in the context of Indian economy. The same is also shown with the help of the views of some of the experts of Indian financial market. Thus we can conclude that Repo rate being a small term has a multiplying effect on the economy.

Limitations of the study:- Though inflation is directly affected by Repo rate but repo rate is not the only factor

affecting inflation. Other factors like oil and petroleum prices also have an impact on inflation. While doing the analysis the same has been ignored and thus this assumption may not hold good in reality.

GDP of a country is affected by several factors and not only repo rate. So to establish a relationship between the two we have to assume that Repo rate is the only factor affecting GDP.

In the case of foreign exchange rates and fiscal deficit also we have assume that all other factors affecting these two terms doesn’t exist. Thus the assumption may not hold good in reality

For the purpose of analysis, data used are real and not imaginary hence while showing the relationship it may happen that the relationship may not hold good. This is due to the assumptions as said earlier points.

All data used in the project are secondary data as the project mainly deals with macroeconomic factor and collection of primary data is not possible at the moment and also due to the constraint of time collection of secondary data is not possible

6. Webliography

http://www.global-rates.com http://www.hindustantimes.com http://www.indexmundi.com http://data.worldbank.org http://currentaffairs-businessnews.com http://trak.in http://www.inflation.eu http://www.tradingeconomics.com http://qna.rediff.com http://en.wikipedia.org http://www.simpletaxindia.net http://www.riksbank.se http://www.oanda.com http://in.reuters.com http://www.business-standard.com

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