Economics behind the Rate Hikes in India by RBI

To understand this we need to first look upon some important Rates which are depicted below:

• Repo Rate: It is the interest rate at which RBI lends money to Banks for short term(Generally for 1 to 2 weeks)[ currently it is  6.25%]. High repo rate makes borrowing expensive for Banks.
• (Let us see how Repo rate has changed over the years)

• Reverse Repo rate: It is the interest rate which RBI pays to banks for holding securities of Bank.[Currently it is approx. 6%]. High Reverse repo rate encourages Banks to lend their money to RBI instead of lending to general public. This causes restriction of money supply in the banking system and vice versa.
• (Let us see how Reverse Repo rate has changed over the years)

• SLR ( Statutory Liquidity ratio) :  It is the minimum portion of Bank’s liabilities which bank has to deposit with RBI in the form of liquid assets i.e. cash, gold etc.[ currently it is approx.19.5%]. High SLR causes less amount available with banks for lending and vice versa.
• (Let us see how SLR has changed over the years)

• CRR ( Cash Reserve Ratio) : It is the minimum portion of Bank’s deposit, which are required to be kept in Cash. Bank’s do not keep that cash with themselves but with RBI.[ Currently it is approx. 4%]
• (Let us see how CRR has changed over the years)

Let us understand these ratios with an example:

Suppose a “ XYZ ”  bank has recently started its operation. We all know that Banks business is to lend money. To lend money, first it needs to borrow money. So to borrow money the Bank goes to RBI and ask for say Rs 100 to start the operation of lending. RBI agrees to pay Rs.100 but with some obligation and signing of contracts. The RBI says, out of Rs.100, Bank needs to put Rs.4 in hot cash( CRR=4%),  Rs. 19.5( SLR=19.5%)  with me and remaining Rs.76.5  can be used for lending to the businesses. In return, Banks need to pay interest of Rs. 6.25 to RBI ( Repo Rate=6.25% ) and RBI will pay interest of Rs.1.41 to Banks( Reverse Repo rate= 6%) on Rs. 23.5 deposited with RBI.

How RBI uses these rates to control Inflation??

Repo rate, Reverse repo rate, SLR and CRR helps in controlling the supply of money into the market which eventually control the inflation/deflation, as illustrated above.

Whenever the Inflation is high, the RBI increases the Interest Rates[ Repo Rate] to tight the supply of money. For example, any rate hike on Repo means banks have to pay more interest to RBI,  Banks in turn passes on the rate of interest on loans to borrower, which eventually increase the cost of borrowing , so borrowers will take less credit from Banks and ultimately there purchasing power will reduce and so as the spending.

Less spending      leads to              Less Inflation

Higher Spending    leads to              Higher Inflation

To tightening the supply of money , the RBI may also increase SLR and CSR rates, that means banks will have less money in their hand for lending-   which also reduces the inflation as we discussed above.

So do we see more such Rates Hike in coming time ??

The Answer would most probably be, Yes! The reason being the crude is at all-time high at 72 Dollar/ barrel as compared to 50 Dollar/ barrel last year and Rupee has depreciated from Rs.64 to Rs. 70 in last one year.  The rise in prices of crude and dollar together has made Indian economy in doldrums, as it has  led to higher inflation in recent times, and widen the CAD( Current Account Deficit) as well . If CAD is not encountered properly it may leads to lowering of credit rating of the country. In order to counter all these mess , the RBI will have to sought for rate hike as it will lead to less spending, less spending means less consumption, less consumption means less burden on CAD and lower inflation. However, all these will make economy on track in terms of inflation and CAD but it will take a toll on GDP of the country as it will slow down the growth of the economy.  So guys balancing the economy is not everyone cup of tea, let us see how RBI manages all these in coming time.

Rate Hike Good or Bad for the Market ??

In simple term, rate hike leads to slowdown of the economy. The Stock Market in general represents the picture of economy. Therefore, Rate Hike generally not bad for the Stock Market.