Repo Rate, if not understood well it could derail your investment growth.
RBI hikes repo rate by 50 bps to 5.4%, this news flashed on 05 Aug 2022 on every social media platform, TV screen, Radio, News Paper whatever the online or offline media available of communication.
But the next question arises in our mind, How would this repo rate hike impact me?
Whether a hike in repo rate is good or bad for me?
How will my future goals be affected by this repo rate hike?
How to reposition myself based on this RBI repo rate hike?
Are interest rate rises good for savers?
Are interest rate rises good for the share market?
How interest rate affect the inflation?
Such a lot of questions come to our mind.
So, if such questions also come to your mind, then this article then this article would be great learning.
But here is a warning, this article is lengthy. Only read further if you are really serious about your financial wellbeing.
So, let us start to understand these rate hikes and be able to take wiser decisions based on such repo changes.
To understand it, let’s first understand from the perspective of the central bank’s point of view.
Every country has its own central bank like India has Reserve Bank Of India.
The US has a Federal Reserve System.
The Bank of England is the central bank of the UK.
The Reserve Bank Of Australia is the central bank of Australia.
The People’s Bank of China is the central bank of China.
State Bank of Pakistan is the central bank of Pakistan.
Each central bank has some tools to control two very major things.
To boost the economy of their country
To control the inflation of their country
These two indicators are just like two horses which move in opposite directions.
If the central bank gives the push to the economy, then inflation becomes high, and it controls the inflation then the economy slows down.
So the central bank always keeps both of them in target range.
Let’s understand with an example.
Suppose a person earning Rs.10000 each month and paying a loan EMI of Rs.1000.
When the interest rate will increase then he has to pay more EMI each month.
This means he has less cash in hand to spend.
When he will have less money in hand then he will spend less.
If he would spend less, then there would be less demand.
If there will be less demand, the prices will fall.
If prices fall, the inflation will fall.
When inflation falls, people will have more money to spend.
So, with increase in interest rate the inflation falls.
Now let’s see from another perspective.
If interest will increase, then the cost of loan will increase.
If the cost of loan increases, then there will be less demand for loans.
If demand for loans will be less, then there will be less expansion of future projects due to less money.
If less expansion of future projects, the economy will be decelerated.
So here we see, with increase in interest rate the economy decelerates.
To ease off the inflation with increasing interest rate, the economy of that country also decelerates.
So here the central bank uses its special tools to control both.
These tools are as follows
Repo
Reverse Repo
CRR
SLR
In India, RBI has an inflation target in terms of consumer price index (CPI), once in five year.
From 1st April 2021 to 31st March 2026 the central government retained the inflation target.
The CPI inflation target kept at 4% with upper band limit to 6% and lower band limit to 2%.
For this RBI constitutes a 6-member Monetary Policy Committee under RBI act to determine the policy rate to achieve the target inflation.
But if RBI fails to achieve that inflation target then it tells central government
1. The reasons for failure to achieve inflation target.
2. Corrective actions proposed by the bank.
3. An estimated time period within which the inflation target will be achieved based on proposed corrective actions.
So the central bank aims to achieve this inflation target by revising Repo (Repurchase Obligation) rate.
Repo Rate:
The rate at which RBI gives the loan to commercial banks against some collaterals of government and other approved securities, called the repo rate. The 100 bps (basis points) is equivalent 1%. If RBI increases the repo rate by 50 bps, then it’s equivalent to 0.50%.
Reverse Repo:
When commercial banks kept their excess liquidity in RBI, the interest rate given on that called reverse repo rate.
One thing we should keep in mind is that RBI never takes loans from commercial banks.
Only commercial banks either take loans or deposit their excess liquidity with RBI.
The reverse repo rate always remains below the repo rate.
When repo rate changes, it has cascading effects on other things also.
Let’s understand the cascading effects of repo rate.
Suppose the commercial bank has to borrow 100 Cr from RBI at 5.4% repo rate instead of the earlier repo rate of 4.9%.
It means RBI intentionally disincentivizing the banks to borrow.
Now if banks borrow at a higher rate from RBI, then it will give loans at higher rates than repo rates.
Here RBI again discourages the people indirectly to take loan at higher rate so that less money comes in the hand of people.
So that demand side inflation reduces.
But if things do not stop here then the most effective tool used by RBI is CRR.
CRR:
Cash reserve ratio, the average daily balance that a bank is required to maintain with the Reserve Bank as a percent of its net demand and time liabilities (NDTL)
It directly impacts the functioning of commercial banks.
Whenever MPC revises the repo rates then it may or may not change the CRR.
If RBI changes both repo as well as CRR, it means inflation is out of control and RBI is taking strict action to control it.
You can understand it with a simple example.
Suppose in a family of four members which have a father, mother, two kids.
He gives money on every salary day to his wife for home expenses and kids for pocket money as most of the salaried family wait for that day.
Now father is facing a challenge to achieve some sort of financial goal or to handle some other expenses which are on the way in the next couple of months.
Now at the first step he starts to give less money to his wife so that his kids demand less money from her mother for any other expenses.
But he still gives the same amount of pocket money to his kids and kids feeling happy.
By doing all this, he still feels incapable of achieving his goal and he starts to give lesser pocket money to his kids also.
Now he directly sucks out money from his home in a blunt way & everyone with this action is annoyed with him.
But father has no other option except giving less money at home to achieve that goal.
In the same way RBI first controls inflation indirectly by increasing the repo rate.
If the situation does not improve, then it changes the CRR along with the repo rate, which is a more blunt way to control inflation.
Now let us understand the impact of CRR change on ourselves.
Suppose a bank has 100Cr NDTL (Net Demand and Time Liability).
To understand NDTL in simple language, we first understand how banks work in a broader way.
Bank has two sources of cash inflow.
The first is CASA (Current Account & Saving Account) and FD/RD.
When we withdraw money from the bank, the bank cannot say it has no money and come another day.
It has to maintain sufficient balance to fulfil this requirement which is called Net Demand.
Now FD/RD also have some tenure say 5 years.
After that bank has to pay principal amount & interest earned on it with an applicable interest rate which is called Time Liability.
So banks have to maintain that amount of balance to fulfil the NDTL requirement.
| Rs (Cr) | ||
| NDTL | 100 | |
| Cash Reserve Ratio | 4% | 4 |
| Statutory Liquidity ratio | 18% | 18 |
| Net Amount left with bank to run business | 78 | |
| Cash Reserve Ratio | 5% | 5 |
| Statutory Liquidity ratio | 20% | 20 |
| Net Amount left with bank to run business | 75 |
We can see from the above illustration that when CRR & SLR were 4% & 18% respectively.
Bank has money to run the business at Rs.78 Crore.
But when CRR & SLR changed to 5% & 20% respectively, the bank left with a lesser amount of Rs.75 Crore to run business.
SLR:
Every bank has to maintain in India assets, the value of which shall not be less than such percentage of the total of its net demand and time liabilities (NDTL) in India
If a bank has less money to run business, then a lesser amount of loan would be distributed by banks.
Again, a lesser amount of cash will come in the hands of people to spend.
If less amount of money will come in circulation, then inflation will reduce & get loans at higher interest rates.
Now understand how it impacts the investment decision in a broader way.
Suppose a product which costs in the international market at $1 and the price of $1 in India is Rs.79.
But due to inflation the cost of that product doubled to Rs.158 in India.
Now the international buyer will not give us $2 for the same product. He will say it is your problem and less buying from India will happen.
If less people buy from India, then credit rating agencies will give lesser ratings.
If there is a lesser rating, then lesser investment will come.
If lesser investment will come in India, lesser growth of India would happen.
Importers have to pay more money but it is good for Exporters.
So for your investment in the equity market, you should analyze the import/export impact on your invested companies.
If a bank’s interest rate rises, then the FD rate also increases.
So here long-term FD should do rather short term which is good for fixed income investors.
As we know with rise of interest rate the lesser surplus amount left in hand.
If a lesser amount is left in hand, then a lesser amount to invest in the equity market due to which again the equity market would fall which you have seen in April -June months.
Conclusion
RBI has some tools to control two very major things.
To boost the economy of their country.
To control the inflation of their country.
If the central bank gives the push to the economy, then inflation becomes high, and it controls the inflation then the economy slows down.
With increase in interest rate the inflation falls.
With increase in interest rate the economy decelerates.
RBI always aims to achieve this inflation target by revising Repo (Repurchase Obligation) rate.
The reverse repo rate always remains below the repo rate.
If RBI changes both repo as well as CRR, it means inflation is out of control and RBI is taking strict action to control it.
Long-term FD investors should do FD for higher time frame rather short term when interest rates are higher.
So, in the overall scenario we have seen that with increase in repo rate how it impacts our life directly & indirectly.
If we would have a good understanding of these repo rate changes then any change could be used in our favor.