RBI announces rate cut

D.Subbarao, the RBI governor has announced a rate cut of 50 basis points (pbs) on the repo & reverse repo rate on 4th March 2009. Now the repo rate stands at 5% (earlier 5.5%) and the reverse repo stands at 3.5% (earlier 4%). These rates, a year ago were 7.75% and 6% respectively (in Jan 08). During mid-2008, the repo rate was around 9%, while the reverse repo was pegged at 6%.
Okay, what does this reduction in the rates signifies?
If you recollect my earlier blog on the Third Quarter Review of Monetary Policy, we discussed on the reverse repo rate and the repo rate and how RBI uses them as a tool to control / loosen the availability of money in the system (called liquidity).
So, now that the RBI has reduced the repo rate, the banks can borrow from RBI to fund its activities. Also, the RBI has reduced the reverse repo rate. What does that mean? Now the banks deposits with RBI will earn only 3.5% return. Is it good? Do you know how much your bank gives interest on your savings bank account? Check with should be somewhere in the range of 3.5%. So, the banks pay 3.5% and gets 3.5% return on their deposit!! Are they into charity operations? No. So what they will have to do? They have to increase the spread (the difference between the rate at which they borrow and the rate at which they earn). Now that the earning is known, so to increase it, they have to cut the deposit rate - simple. Why I took the example of Savings bank account is that, we all know that product and also it is the lowest interest paying deposit account.
Coming back to the banking side. They know that borrowing from RBI is cheap and also know that placing deposit with them will not earn much money. What they will do? They are now forced to lend to customers (other than RBI) to generate revenue to cover their cost. Else, they will sink. This will sound simple, theoretically. But in reality, it is not that easy to lend in this economic situatoin. Banks are very cautious in lending money. Forced lending will land them in trouble.
So banks are looking at various opportunities of reducing their borrowings (offering lower rate of Interest on their borrowing products like Deposits). They lend to top notch clients, look for more securities etc., Most of you know that Mar 15th is the last date for the Advance tax remittance for Income Tax. In the given economic conditions, corporates & business people will look for money to pay their tax dues. So, in my opinion the banks will start reducing the rates after 15th March.
Poor banks, they are now having funds and are looking for borrowers! Are you credit worthy, you can easily get loans and help the banking system. Look out for reduction in the Home Loan interest rates, FD rates, SB rates, etc.,
Let us wait and watch!


Bala on Mar 5, 2009, 11:41:00 AM said...

Hello Gopal,

If I say "the article is good", it's an understatement.

Fantabulous writing, that even a layman can understand these critical terms.

Pls keep up the good work going !!


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