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RBI’s Interest Rate Policy and Its Impact on Indian Economy

Reserve Bank of India(RBI) is the central bank of India. Its main f unction is to establish monetary stability inthe country. For this, it is equipped with independence in f ormulating and implementing monetary policies inorder to maintain price stability and adequate money supply in the system. RBI takes dif f erent expansionaryand contractionary steps to achieve the same and utilizes its tools such as Cash Reserve Ratio(CRR),Statutory Liquidity Ratio(SLR), Bank Rate, Open Market Operation(OMO) and Liquidity AdjustmentFacility(LAF) f or this. The use of these tools varies the supply of money in the system. Whenever RBI wants to reduce moneysupply i.e. curb inf lation in the country it f ollows contractionary measures, whereas when achieving growthis the target it takes expansionary measures.

Why are interest rates important for an economy?

Amongst all the rates, it is the Repo rate which inf luences most the given money supply in the economy.Repo rate is the rate at which the banks borrow short- term f unds f rom the RBI. It is a secured nature ofborrowing similar to a loan against f ixed deposits availed by individuals during emergencies. RBI raises reporate to increase the overall cost of f unds in the banking system. Higher costs will keep in check the demandf or f unds. If the central bank hikes its repo rate, it becomes costly f or banks to borrow money f rom RBI sothey in turn hike the loan interest rates at which customers borrow money f rom them to compensate f orthe hike in repo rate.

In the f ollowing graph, the trend in inf lation, growth and interest rates have been plotted f or the past sevenf inancial years f rom 2006-07 to 2012-13 have been plotted.

Interest rates have high inf luence on both growth and inf lation. Higher the interest rate, higher is the costof capital and contributes to slowdown investment in the economy. Interest rates are a signif icant f actor indetermining the economic environment in which investment has to take place, especially when manycompanies are not cash rich. High interest rates also impact FDI due to the uncertainty in the exchange rateas the market expects interest rates to eventually f all.

Lower the interest rate, higher is the supply of money in the economy and greater purchasing power ofindividuals. This will result in increase in the price of Goods, since there is more demand and less supply ofthe goods. Manipulating interest rates thus creates a variation in growth and inf lation in the economy.

Thus Interest rate is amongst the most signif icant components of the cost of many companies anduncertainty of this variable only amplif ies overall uncertainty in which investment decisions have to be made.RBI has to maintain a balance between these two f actors which runs the economy. RBI's interest rate policycan help anchor expectations and reduce uncertainty.

Year Growth inf lation Interest Rate

2006-07 9.57 6.50 7.75

2007-08 9.32 4.80 7.75

2008-09 9.00 8.00 5.00

2009-10 8.59 4.10 5.00

2010-11 9.32 9.60 6.75

2011-12 6.21 8.80 8.50

2012-13 4.96 7.80 7.50

Source: Planning Commission

Table 1. Historic data of growth, inf lation and Interest Rate

As per Table 1, f rom 2008 to 2009, the inf lation rose by almost 4 percent and the repo rate was reduced by2.75% as the growth rate was steady at 9% whereas f rom 2011 to 2012 the inf lation as compared toprevious year lowered its pace to 8.80% and growth suf f ered. Central Bank in 2011-12 had to theref oreincrease Repo rate to control inf lation.

Current Indian Scenario

The global economic activit ies have slowed and risks remain high, most recently on account of uncertaintyover policies of systemic central banks. On the domestic f ront, macroeconomic conditions remain weak,along with supply constraints, lacklustre domestic demand and weak investment sentiment.

Annual inf lation rate, based on WPI has been currently showing a downward trend f rom 4.89% in April 2013to 4.7% in the month of May. Many high weightage items f rom the basket had lowered its price as comparedto previous year. Petrol that occupies around 1.09% of weight age in WPI has its contribution decreased by4.43% due to global f alling in prices. Basic metal and alloy products occupies a huge posit ion of 10.74%has lowered its contribution in growth of WPI by 1.5%. The similar has been the trend with Iron and Semis.Also the global gold prices are f alling. All this provides central bank a room to lower down the interest rateto prosper growth in the economy.

Due to the remarkable economic growth of India over the recent years compared to other nations, increasein f oreign currency inf low caused the demand in multiples in India. Inf lation has moderated as projectedhowever the depreciation in rupee value and imbalances in the commodity markets pose a big challenge.Given that f ood price are still high, the inf lation f igures will be inf luenced by ef f orts to break f ood inf lationpersistence and also the impact of the ordinance passed f or the f ood security bill.

Comaparison with other Economies:

Various steps were taken by other developing nations in order to control their monetary policy andeconomy. Among the developing nations, Indonesia responded to outf lows and market volatility byunexpectedly raising interest rates - the f irst Asian central bank to do so since 2011 - in a bid to support itscurrency, while Brazil said it would scrap a tax on f oreign exchange derivatives as the real weakened. Othermajor developing countries with large f oreign f inancing needs such as South Af rica and Poland are alsoseen at risk.

If we check the current scenario of developed nations, they have a very low interest rate. US Fed has keptits f und rate to as low between 0-0.25%, Japan’s call is between 0-0.10% whereas European Central Bankhas kept its key interest rate to 0.5%. This shows to achieve growth we need to keep these rates low, butagain the central bank must have a control on money supply in order to curb high inf lation.

Interest Rate and Reserve Bank of India:

Historically, f rom 2000 until 2013, India Interest Rate averaged 6.6 Percent reaching an all t ime high of 14.5Percent in August of 2000 and a record low of 4.3 Percent in April of 2009. Due to t ight cash conditions inthe system, banks have been borrowing an average Rs.80,000 crore daily f rom RBI. Due to worseningliquidity conditions, bank borrowing shot up to Rs.1.2 trillion f rom the central bank in December 2012. Thatapart, banks have also been tapping the ref inance f acility of RBI. Also, RBI has inf used about Rs.1.3 trillioninto the system last f iscal through so-called open market operations.

RBI (Reserve Bank of India) had to control this excess liquidity in our economic system. The RBI in its lastreview meeting decided to keep the repo rate under the liquidity adjustment f acility (LAF) unchanged at 7.25per cent and to keep the cash reserve ratio (CRR) of banks unchanged at 4.0 per cent of their net demandand time liabilit ies. The Central Bank warned of upward risks to inf lation posed by a f alling rupee andincreases in f ood prices.

The Reserve Bank’s monetary policy stance will be determined by how growth and inf lation trajectories andthe balance of payments situation evolve in the months ahead.

Inf lation has moderated as projected however the depreciation in rupee value and imbalances in thecommodity markets pose a big challenge. Given that f ood price are still high, the inf lation f igures will beinf luenced by ef f orts to break f ood inf lation persistence and also the impact of the ordinance passed f orthe f ood security bill.

Recent measures to dampen gold imports are expected to moderate the current account def icit in 2013-14f rom its level last year. The main challenge is to reduce the current account def icit to a sustainable leveland the short term challenge is to f inance it through stable money f low.

Conclusion

Interest Rates are very important tool f or an economy. It determines country’s growth, its inf lation, value ofits currency, indirectly the level of employment and investments prospects in the country(in the f orm of DII,FII, FDI). To achieve an open economy, India should be open to investments thereby reducing prevailinginterest rates taking into consideration the inf lation. Again with continuous depreciation of Rupee in lastf ew weeks, indicates the need to absorb liquity in terms of Rupee to stabilize the currency.

Also if we see the trend, even though Central Bank reduced its repo rate, the same has not beentransf erred to the consumer by banks. The lending rates have not decreased by the same percentage asexpected by RBI. Thus there has been not much investment on the growth f ront. This leads to a questionas to whether f urther reduction in interest rate by Central Bank would provide a helping hand to growth ofthe country or will merely increase the money supply(causing inf lation) and providing high prof it makingopportunit ies to banks.

The big question still remains to be seen is that with an inf low of Rs. 1.23 lakh crore in the economy in thename of f ood security bill , will it boost the money supply and decrease prices or will the spending in the

elections cause f urther create a hole in government’s treasury!

[The article has been written by Neha Agarwal and Utkarsh Tathagath. They are presently pursuing theirMBA from NMIMS, Mumbai.]