Repo Rate and It's effect on Indian Economy


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Repo Rate and It's effect on Indian Economy

  2. 2.  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.
  3. 3. Method of data collection:-Secondary sources:-The data for study has been collected from various sources: Books Journals Internet sourcesStatistical Tools Used: Simple tools like bar graphs, tabulation, line diagrams havebeen used.
  4. 4. The Reserve Bank of India (RBI) is Indias central banking institution, whichcontrols the monetary policy of the Indian rupee. It was established on 1 April1935 during the British Raj in accordance with the provisions of the ReserveBank of India Act, 1934. The share capital was divided into shares of ₹100each fully paid which was entirely owned by private shareholders in thebeginning. Following Indias independence in 1947, the RBI was nationalizedin 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
  7. 7. SUPERVISINGAUTHORITY/REGULATORAND SUPERVISORADVICESGOVERNMENT FORSALE AND PURCHASEOF SECURITIES.REGULATES THEBANKS AND NBFCs ININDIA.ADVICES GOVT. ON HOWMUCH INTEREST IS TO BEALLOWED ON SHORT/LONGTERM CREDIT.1.2 MONETARY POLICYA Tool used to influence Interest rates, Inflation and credit availability through changes insupply of money available in the economy .1.2.1 Expansionary policyExpansionary policy increases the total supply of money in the economy used to combatunemployment in a recession by lowering interest rates,1.2.2 Contractionary policyContractionary policy decreases the total money supply involves raising interest rates inorder to combat inflation increasing interest rates slows the economy by making fundsmore expensive to firms, and promotes consumer savings which decreases revenues byfirms.
  8. 8. 1.3.1 Bank Rate :-1.3.2 Call Rate :-1.3.3 CRR :-1.3.4 SLR :-1.3.5 Repo (Repurchase) RateRepo rate is the rate at which banks borrow funds from the RBI to meet the gapbetween the demand they are facing for money (loans) and how much they have onhand 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 muchmoney floating in the banking system.
  9. 9. Liquidity adjustment facility is a monetary policy tool which allows banks to borrowmoney through repurchase agreements. LAF is used to aid banks in adjusting the dayto day mismatches in liquidity. LAF consists of repo and reverse repo operations. Repoor repurchase option is a collaterised lending i.e. banks borrow money from Reservebank of India to meet short term needs by selling securities to RBI with an agreement torepurchase the same at predetermined rate and date. The rate charged by RBI for thistransaction is called the repo rate. Repo operations therefore inject liquidity into thesystem. Reverse repo operation is when RBI borrows money from banks by lendingsecurities. 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 systemThe introduction of Liquidity adjustment facility in India was on the basis of therecommendations of Narsimham committee on banking sector reforms. In April 1999,an interim LAF was introduced to provide a ceiling and the fixed rate repos werecontinued to provide a floor for money market rates.
  10. 10. 2.1.3 What Does Basis points means??2.1.4 Types of repo rate:- Over night repos Term repos Open repos2.1.5 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 isknown as the transmission mechanism. The transmission mechanism is actually notone but several different mechanisms that interact. Some of these have a more or lessdirect impact on inflation while others take longer to have an effect. It is generally heldthat a change in the repo rate has its greatest impact on inflation after one to two years.
  11. 11. 2.2 Transmission Mechanism :-
  12. 12.  If the interest rate rises, banks choose to decrease their lending and instead buybonds. Companies find it more difficult to borrow money. Companies that are either unable or unwilling to borrow must cut back theiractivities, postpone investment and so on, and this dampens activity in theeconomy.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.
  13. 13.  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 othercurrencies Results in a capital inflow and increased demand for Rupees Which strengthensthe Exchange Rate. Fall in exports & increase in imports Lower Import Prices & Reduction in demand Lower Inflation.
  14. 14. 3.1 Repo Rate Vs. Inflation :-9.886.004.887.257.258.9011.7010.908.306.40- -1210-1109-1008-0907-08Repo Rate (%) (annual Average)3InflationLast 5 year comparison of Repo rate and Inflation
  15. 15. 7.75 7.254.886.007.9040.275546.151547.415345.615748.13173638404244464850- 2009 2010 2011 2012Repo Rate (AnnualAverage)6Yearly Average Exrate5Last 5 year comparison of Repo rate and Exchange rate.
  16. 16. 2007 2008 2009 2010 2011 2012Repo Rate (Annual Average)7GDP6Last 7 years comparison of Repo rate and GDP
  17. 17. FII stands for Foreign Institutional Investment. Here we want to show how high inflationor inflamatory conditions are unfavourable for FIIs and discourage them to invest insuch conditions.Suppose a foreign investor wants to invest in Indian Economy. He has $100000 toinvest in Indian market. At the time of investment exchange rate was 50/$. So his grossamount of investment in Indian currency ( INR) is 50 lakhs. During the year he earnsRs100000 as profit which brings his gross investment at the year end to Rs 51 lakhs.This picture is bright from the investors point of few given the exchange rate remainsconstant. But due to inflation it turns out that the exchange rate is now 55/$. Now if hewants to withdraw his money from Indian market . Gross amount he will get is $ 92727which means he incurred a loss of $ 7273 within a year in Indian market. Thus we seethe gain in Indian currency is outcast by loss due to foreign currency fluctuation anddiscouraging FIIs to invest in high inflation conditions. The same can be shown with thehelp of an bar graph-10,00020,00030,00040,00050,00060,00070,00080,00090,000100,000Initial outflow final inflowSeries2Series1Here series 1 is hismoney before andafter investment andseries 2 representsloss suffered by him.
  18. 18.  Decrease in Repo rate Increase in money supply ineconomy Increase in Demand of goodsin economy Increase in GDP GrowthRate Increase in the Averageincome of people andcorporate Increase in Tax Revenue ofthe government Decrease in fiscal deficit ofthe government for theperiod Decrease in Repo rate Decrease in Value ofdomestic currency Increase in Exchange Rate Increase in Export of goods Increase in inflow of foreigncurrency Decrease in Current AccountDeficit
  19. 19. 7.257.757.254.886.007.900.504.905.203.805.105.70- 2008 2009 2010 2011 2012Repo Rate (Annual Average)Fiscal Deficit8Last 6 years Repo rate comparison with fiscal deficits.
  20. 20. 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 sufferingfrom macroeconomic problems like high inflation, slow growth rate and high CurrentAccount Deficit. First of all the countries included in “BRICS” to face the downturn ingrowth was seen as the sign of the coming slow growth period or the end of the muchtalked about double digit growth expectation. Facing the high inflation problem RBI hadraised the lending rate 13 times between March’10 to October 2011 to contain theinflation which was touching double digits. This had led to clamor by industry to cutrates and spur industrial and economic growth that has slowed down considerablyduring the past few quarters. And with CAD hovering over 4% of GDP , the economywas facing a downgrade in investment ranking risk from many investment rankinginstitutions.
  21. 21. The Reserve Bank of India (RBI) cut interest rates for the first time in three years by anunexpectedly sharp 50 basis points to give a boost to flagging economic growth butwarned that there is limited scope for further rate cuts. The RBI cut its policy repo rateto 8%, compared with market and expert expectations for a 25 basis point cut. It alsowarned that Indias current account deficit, which widened to 4.3% of GDP in theDecember quarter, is "unsustainable" and will be difficult to finance given projections oflower capital flows to emerging markets in 2012.RBI left unchanged the cash reserveratio (CRR), the share of deposits that banks must hold with the central bank, at4.75%, in line with expectations, after cutting it by 125 basis points since January toease tight market liquidity.Reserve Bank Governor D Subbarao said liquidity conditions are moving towardsnormal after several months of acute shortage of cash in the banking system, but alsosaid the RBI would take "appropriate and proactive" steps if needed to restore liquidityto comfortable levels.
  22. 22. 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 realinterest rates realistic. Then, the fiscal side needs to be controlled to prevent crowdingout of the private sector and available liquidity is well distributed.“NITESH RANJAN, CHIEF ECONOMIST, UNION BANK, MUMBAI :-"A very bold step indicating RBIs change in stance. This will help in arresting growthgoing below the trend level. One can expect the cost of fund and capital goingdown, which will encourage consumption and investment demand."Given the inflationary risks, as mentioned in its (RBIs) macro report, I think the nextrate action may wait till first quarter review in July, by when more clear trend on growthand inflation will emerge.“GAURAV KAPUR, SENIOR ECONOMIST, ROYAL BANK OF SCOTLANDNV, MUMBAI :"I think perhaps another 25 basis points in the first half of this year is likely. I thinkthe room for further cuts is limited. The actual action is to support growth withouttaking eyes off inflation."One comfort factor for the RBI is core inflation, which has fallen below 5percent, which shows the demand side pressures are easing."
  23. 23. The 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 toincrease inflation. Both the economic factor are closely related to each other and Reporate has a great influence over the inflation rate. Repo Rate and foreign exchange rate also share a inverse relationship between them. Asincrease in Repo rate leads to strengthening of domestic currency and thus leading to fallin exchange rate due to strengthening of domestic currency. Repo Rate and GDP of a country are inversely related. That is if repo rate decreases theGDP of an country increases. This is because of increase in money supply in economyleading 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 relateddirectly by the relationship is based on two factors which are affected by Repo rate asshown earlier in the analysis part. Reserve Bank of India (RBI) being the apex bank of the country plays an important rolein the economy. As depicted in earlier section it has many functions in the economyranging from being the banker to the banks to taking decisions regarding monetarypolicies. RBI uses Repo rate as a tool for controlling money supply in the economy andalso to bring the inflation and other factors under control. And the situation case studyshows the effectiveness of the policies relating the repo rate and its utilization as amonetary tool for controlling the money supply.
  24. 24. Repo Rate which is a very well-known term in our economy plays a vital role in it. Fromaffecting the inflation directly to influencing the foreign exchange rate, repo rate plays acentral role in the money supply of an economy. The findings of the analysis done earlier area proof of how important repo rate is for the economy and how effectively it is used by RBI inthe context of Indian economy. The same is also shown with the help of the views of some ofthe experts of Indian financial market. Thus we can conclude that Repo rate being a smallterm 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 factoraffecting inflation. Other factors like oil and petroleum prices also have an impact oninflation. While doing the analysis the same has been ignored and thus this assumptionmay not hold good in reality. GDP of a country is affected by several factors and not only repo rate. So to establish arelationship between the two we have to assume that Repo rate is the only factoraffecting GDP. In the case of foreign exchange rates and fiscal deficit also we have assume that allother factors affecting these two terms doesn’t exist. Thus the assumption may not holdgood in reality For the purpose of analysis, data used are real and not imaginary hence while showingthe relationship it may happen that the relationship may not hold good. This is due to theassumptions as said earlier points. All data used in the project are secondary data as the project mainly deals withmacroeconomic factor and collection of primary data is not possible at the moment andalso due to the constraint of time collection of secondary data is not possible
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