Interest towards Interest rates

The topic of interest rate has never ceased to stir up a debate in the monetary policy circles. In recent times, there’s always speculation as to whether the RBI will reduce interest rates further. Analysts go to the extent of labelling Governor Rajan a hawk for his purportedly hawkish stance on monetary policy and a dove at times he chooses to slash the repurchase rate. Just a little bit of a primer as to what the repurchase rate means – It is the interest rate at which the scheduled commercial banks borrow from the RBI on a short term[overnight/tenor] basis. In return, the banks have to pledge government securities as collateral with the RBI. So, for example, if a bank wants to borrow Rs.10 crores[repo auctions begin at a minimum of Rs.5 crores and multiples of 5 crores thereafter], it has to pledge government securities worth Rs.10 crore as collateral and agree to repurchase them for Rs.10 crores + Rs.17808 [a day’s policy repo rate at 6.5% for overnight repos]. Hence the name “repurchase rate” and in short, repo rate a.k.a interest rate.

Taking this a little deeper, the government securities pledged by the bank as collateral cannot come from its SLR [Statutory Liquidity Ratio]. SLR right now stands at 21.25% after Governor Rajan slashed it by 25 basis points from 21.5% in the April 2016 monetary policy review. SLR, a part of the reserve ratios[the other one being the CRR], is the share of Net Demand and Time Liabilities[NDTL, e.g – Savings bank account, Fixed Deposit bank account etc.] that must be held by banks in the form of assets such as government securities, gold or cash. CRR is currently at 4%, which means that banks have to maintain 4% of its NDTL as cash reserves with the RBI. These ratios ensure that the bank holds ~25% of its NDTL assets with the RBI at all times, so a bank becoming insolvent is only an adverse possibility. Also, in a macroeconomic sense, these are some important factors that control liquidity in the economy.

Let us try to understand exactly that – how liquidity is maintained in the economy. The Government of India issues securities as means to fund its deficit/raise capital. The RBI buys/sells these securities from/to banks via Open Market Operations[OMOs]. If RBI feels there’s a lot of money in the system, they sell these securities thereby sucking out excess liquidity. The banks in turn buy these securities since they need them to pledge as collateral for repurchase operations. The liquidity lent to the banks is in turn lent as bank loans to customers. This process, in turn affects the money supply in the system on the whole. Now the theory here is that, in times of low interest rates, the banks are on a borrowing spree from the RBI. This increases liquidity in the system when banks increase their transmission via lending. Extending the theory, this puts a lot of money in people’s hands, which increases their consumption capacity. When consumption increases, the overall demand for goods in the market increases, as a result of which prices of commodities increase. This is what we call inflation. This is the rationale behind the Consumer Price Index[CPI] shooting up every time the RBI pares interest rates.

The inverse of this process is precisely what leads the RBI to increase interest rates primarily to contain inflation. Sensing more than required liquidity in the system, RBI increases policy repo rate to counter inflation. Banks borrow less as a result of this as they do not want to pay a higher interest rate on their borrowings. This, in effect, leads to less lending by the banks. Ergo, less money for the public to spend. The lesser the purchasing power of the public, the lesser is the demand for commodities, which in turn leads to a fall in their prices. This is what we call deflation or disinflation. It is, again, reflected in the CPI which tends to drop when there’s disinflation.

Developing countries like India face the prospect of high inflation as increased public or private spending to boost the economy is always concomitant with rising prices. Suppressing inflation by increasing interest rates tends to stall growth as an offshoot, thereby decelerating the economy. But inflation is directly correlated to immediate electoral gains. And politicians, as they are wont to do, are inclined towards immediate results and are averse to anything that blights their popular opinion. In fact, the former Finance Minister P.Chidambaram, after the drubbing the UPA took in the 2014 general elections, remarked that more than the corruption scandals that prevailed at the time, it was the impact of high inflation[~10%] that caused the UPA’s electoral defeat. The economists are stuck between a rock and a hard place, in the sense that they have the pressure of their political masters and that of their own performance. More often than not, the prudent thing to do is lost somewhere in the interstices between the rock and the hard place.