From UPSC perspective, the following things are important :
Prelims level : Banking rates and markets instrument.
Mains level : Paper 3- Steps taken by the RBI to revive growth and provide stability to economy.
The RBI’s Governor’s ‘bazooka’ announcement earlier today has seen the usually conservative institution and its head pull out the big guns in word and action.
Four steps taken by the RBI
- One, increase the liquidity in the system.
- Two, make sure the lower policy rate is transmitted. Steps one and two are linked.
- Three, give a three-month window for a payback on all term loans.
- Four, take steps to reduce volatility and provide stability.
- Big cut in repo rate: He announced a big cut in the repo rate by 75 basis points (100 basis points make a per cent, so three-quarters of a percentage point) to 4.4%.
- What is the repo rate? Repo rate is the rate at which the banks borrow from the RBI. Banks give ‘eligible securities’ they hold for cash that RBI gives as an overnight loan.
- Banks pay the repo rate as interest for this borrowing.
First two steps of the RBI: Increasing liquidity and ensuring policy rate transmission
- Why lower repo rate matters? When the repo rate is high, banks find it costly to borrow and in turn raise the price of loans to their borrowers.
- Reducing interest for the system: A low repo rate has the overall effect of reducing interest rates for the system. Lower rates make it easier for entrepreneurs to take loans for working capital and for households for homes, vehicles and so on.
- Issue of policy rate transmission: Previous rate cuts have not been ‘transmitted’ by the banks who have not reduced lending rates and have preferred to keep money with the RBI at the ‘reverse repo rate’.
- What is reverse repo rate? This is the rate at which banks lend to the RBI.
How RBI is ensuring transmission now?
- The RBI has now reduced the reverse repo rate by 90 basis points to 4%.
- This cut in reverse rape sharper than the one on the repo rate to encourage banks to borrow from the RBI rather than lend to it.
- How reverse repo rate matters? Banks have preferred to deposit money with the RBI rather than lend it out with an average daily amount of ₹3 trillion being kept with the RBI.
- A reduction of the reverse repo to 4% makes it unattractive to banks to park it with the RBI and banks will be nudged to lend.
- Why bank lending matters for business? Bank lending provides the needed oxygen to businesses for their working capital and longer-term loans.
- Read this as a measure to help banks take the decision to lend rather than play it safe by keeping money with the RBI.
How lock-down slows down the economy?
- Rush to safety for money: If people are in a lock-down, the wheels of the economy begin to grind down and there is a rush to safety for money in the system.
- Freezing of the markets market: Investors begin to redeem their shares, bonds and mutual funds. These redemptions cause a fire sale of assets. Finally, when there are no buyers, markets begin to freeze.
What are the measures taken by RBI to stabilise the market?
- To keep the wheels of the markets well-oiled with cash, the RBI has made ₹3.74 trillion available. This it has done using four weapons.
- The first measure: It has used targeted long-term repo operations.
- RBI will lend money to banks (a total of ₹1 trillion) that can be invested in bonds and other forms of lending instruments.
- What is a hold-to-maturity way? Under the hold-to-maturity way, the portfolio is valued not on the market price but on what the price should be given the rate of interest of the bond, the holding period and the rating of the bond.
- Basically, it allows trades to happen at a price that is not confused with the current pandemic in the market.
- The second measure: The RBI reduced the cash reserve ratio (CRR) by a full percentage point down to 3% for a year.
- The CRR is the percentage of demand and time deposits banks have to keep with the RBI.
- Why CRR and not SLR was reduced? There is another 18.25% of deposits that is also not used for lending under the Statutory Liquidity Ratio (SLR), further reducing the money banks have to lend.
- RBI has reduced the CRR to 3%, freeing up ₹1.37 trillion for banks to lend. CRR has been chosen rather than SLR because this increases ‘primary liquidity’ with the banks a bit better.
- Not only is there CRR rate down, banks now need to maintain 80% of the limit on a daily basis instead of 90% till June 26, 2020.
- The third measure: ₹1.37 trillion will be made available under the emergency lending window called the marginal standing facility (MSF).
- Banks will now be able to borrow 3% of their deposits under this window, up from the current 2%. Basically, RBI is willing to lend more than before.
- How much more? ₹1.37 trillion under this window.
The third step of the RBI: Regulatory forbearance
What is the regulatory forbearance?
What this means is that as economic activity grinds to a slowdown, people will not be able to pay back the loans they have taken for no fault of theirs.
- This could be businesses with loans, households with EMIs on home loans and others with what are called ‘term loans’.
- RBI will allow a moratorium of three months for loan repayment.
- This is a relief especially for small entrepreneurs who have been forced to shut shop and for employees whose incomes have stopped since their place of work is shut.
- It is good that the RBI has looked at the retail part of the market along with the corporate sector for once.
- Working capital loans don’t come under the ‘term loan’ category, and these borrowers can defer paying interest for three months till June 2020.
The fourth step of the RBI: Measures to reduce volatility in the exchange rate
- Fourth is a measure to reduce the volatility of the price of the rupee in international markets by allowing banks to deal in off-shore non-deliverable rupee derivative markets.
- It looks like reform using the crisis to bring about this long-awaited change.
We don’t know if measures taken by the RBI and the government are enough. But what is comforting is that the government and the RBI are working in tandem to deal with this giant killer of a virus.