Monetary Instruments/Terminologies

When I posted about Recession & Depression, GOGI (we fondly call him by that name, the Technocrat our college) appreciated that & asked me to post something similar which will be helpful to non-finance guys also. In this kind of situation where in recession is looming everywhere, I thought of posting about the Monetary Instruments through which Central Bankers try to control the economy.

As you guys may be aware that Inflation peaked out to 12.91% last due to various reasons. I don’t want get into those reasons; otherwise it will become one more post. So to control inflation by controlling money supply in the economy, Central Bank uses CRR, Repo rate, Reverse repo rate & SLRs.

So my today’s topic of posting is giving brief intro about these topics & their effects into the economy…

Cash Reserve Ratio (CRR)

It is the percentage of cash deposits that each bank needs to keep with the Reserve Bank of India.

Presently it is 5%, means for every Rs. 100 deposit each bank needs to keep Rs. 5 with RBI.

Whenever inflation increases, to reduce the money in banking system, RBI takes this route. For 50 basis point (0.5%) change in CRR there will be change in Rs. 20000 crores in the banking system. From this you can assume the extent to which it’s effective.

When inflation started reducing from its peak levels, RBI started reducing CRR from 9% to present levels of 5%. Means it flooded the market with Rs 160000 crore from CRR route to boost the demand so that it can maintain at least 7% GDP.

But still I feel there is lot of cushion left for RBI to cut in this as the pace at which inflation is falling is very aggressive. So I think to avoid the deflation RBI needs to monitor the situation on fortnightly basis reduce the CRR in subsequent steps.

Repo Rate

This is the interest rate at which RBI lends money to the banks. Presently it is 5.5% reduced from it peak levels of 9%. Again this is also one of the standard instruments to control inflation. Increase in the Repo rate leads to

 Increase in the cost of funds for the banks. Due to this banks are forced to increase their PLR (Prime Lending Rate)

 There will be slowdown in the lending from the banks to minimise the gap between the Repo & Reverse Repo.

In this case also I still believe RBI needs to do lot to increase in demand in the domestically. Since ours is domestically consumed and run GDP unlike China which dependent on exports rather than domestic consumption. So I believe still repo of 5.5% in this condition is very high. If you see US maintaining 0 to 0.5%, Japan 0.1%, UK 1.5%, there is lot or RBI to do (of course we cant compare the interest rate & inflation of other country but to compete with other country exports we need to have same/less of cost of funds as those countries specially china!).

Reverse Repo Rate

Its reverse! It is percentage at which banks lend to RBI. It is presently 4%.

Whenever RBI increases the reverse repo rate, banks happily keep most of their reserve funds into the RBI safeguards. Since without taking any risk of lending and possibility of NPA (Non performing assets) they can easily get good returns. So take this advantage RBI increases the reverse repo to suck the money from the banking system.

Presently this is what is happening. Even though RBI wants banks to lend, banks are not lending due to threat present crisis and keeping their funds in the form of reverse repo and SLR. So here also to push the banks to lend instead of keeping it in idle with RBI, Central Banker needs to reduce the reverse repo.

SLR (Statutory Liquidity Ratio) Rate

SLR is the Percentage of deposit that each bank needs to maintain in the form of Cash, gold, government bonds & etc before lending.

Presently it is 24%; means for every Rs. 100 deposit banks needs to have Rs. 24 in the form of above mentioned things.

It is reduced from 25% to present 24% due to contraction in the economy. Initially there was a range-limit for SLR as 40% as upper & 25% as lower limit. But recently lower limit has been removed.

From this tool RBI can keeps check on over leveraging.

I think this is tool which kept our banking system safe from present financial turmoil. Many firms which collapsed due to over leveraging nearly 30-40 times of their total assets.

Over SLR, there is lot of discussion is going now days to increase the credit growth SLR should be reduced and… but that is again questionable in this kind of situation (Overleveraging!).

Prime Lending Rate (PLR)

This is the benchmark interest rate on the basis of which financial institutions decide the interest rates on the various loan products.

PLR is dependent on all the above mentioned instruments. Depending upon RBI moves in those mentioned areas banks keeps on changing PLR.