Understanding RBI’s Policy Post Demonetization
Decision taken by RBI
Opposite to the expectations, recently RBI has kept the interest rates unchanged in the fifth bimonthly monetary policy statement, despite the challenges posed by demonetization.
RBI has also cut the projected Gross Value Added (GVA) growth for 2016-17 by 50 basis points to 7.1 per cent.
RBI has withdrawn the 100 per cent cash reserve ratio requirement that was imposed end of last month.
The central bank said the decision to keep the rates unchanged was unanimously taken by all the six members of the monetary policy committee (MPC).
Factors behind RBI’s decision
Keeping the policy rate unchanged
RBI cited certain factors which can endanger its price stability goals, like:-
- Imminent tightening of U.S. monetary policy
- Rise in oil prices combined with rupee depreciation
- Unstable domestic inflation trends
- Donald Trump’s win has ignited a homeward-bound flight of capital from emerging markets
- It has buoyed the dollar at the expense of other currencies.
Cut in GVA projection
- Unexpected loss of momentum, particularly in industrial activity,in the second quarter due to demonetization.
- Demonetization likely to have the biggest impact on cash-intensive sectors.
Withdrawing 100 percent CRR requirement
The central bank said the decision to withdraw 100 per cent CRR requirement was taken as the government had announced Rs 6 lakh crore of bonds, issued under market stabilization scheme, to clean up excess liquidity.
Key terms explained
What is Repo Rate?
The repo rate is the interest rate at which the RBI lends to banks for short term.It is a secured nature of borrowing similar to a loan against fixed deposits availed by individuals during emergencies.
How does it effect?
If the central bank hikes its repo rate, it becomes costly for banks to borrow money from RBI so they in turn hike the loan interest rates at which customers borrow money from them to compensate for the hike in repo rate.
Lower the interest rate, higher is the supply of money in the economy and greater purchasing power of individuals. This will result in increase in the price of Goods, since there is more demand and less supply of the goods.
What was expected?
- A cut in the repo rate would have ideally brought down banks’ borrowing costs, eventually leading to lower loan rates for companies and individuals.
- It was expected to offset any damage to economic growth and private investment.
- But RBI has kept the rate unchanged to achieve its long term goal of keeping the inflation in control.
CRR and its effects
- Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank.
- Banks do not earn any interest over these deposits with RBI.
- Banks cannot lend this portion of money to corporates or individual borrowers.
- Thus if the CRR rates are increased, It suck the liquidity from the market, leading to lesser money for loans to corporates and increase in the rate of interest over them.
- While decrease in the CRR requirement results in the excess liquidity with the banks for lending purposes.
- Post demonetization, RBI has asked banks to maintain an incremental cash reserve ratio (CRR) of 100% against the deposits they are receiving.
- But in the very recent announcement, RBI has withdrawn this decision. That is expected to set off the effects of keeping policy rates unchanged.
Monetary Policy Committee
- The Monetary Policy Committee (MPC) is a committee of the Reserve Bank of India, headed by its Governor.
- It was set up by amending the RBI Act after the government and RBI agreed to task RBI with the responsibility for price stability and inflation targeting.
- MPC will have six members. Three each will be nominated by the government.
- RBI and each member will have one vote. While the majority voice of the committee will be final in deciding the interest rates and the RBI will have to accept the verdict.
- The Monetary Policy Committee is entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level.
- The MPC will ensure that decisions on interest rates are made through debate by a panel of experts.