General Awareness

April 04, 2017 @ 01:15 PM

April 04, 2017 @ 01:15 PM

K. J. Somaiya Institute of Management Studies and Research, Mumbai

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'Interest rate manipulations and their impact on common man'

General awareness is an area of concern for CAT aspirants and in absence of any syllabus it is guess work on the usage for aspirants. 

But taking stock of those topics which concern you, are bound to help  you in CAT exam. 
 
Today, you will read General Awareness topic: “Interest rate manipulations and their impact on common man” 
 
Historically, from 2000 until 2012, India Interest Rate averaged 6.4700 Percent reaching an all time high of 14.5000 Percent in August of 2000 and a record low of 4.2500 Percent in April of 2009. 
 
In India, interest rate decisions are taken by the Reserve Bank of India's Central Board of Directors. RBI manipulates the money supply or liquidity in the economy by changing the rate of interests to achieve the desired results like low rate inflation, better GDP growth rate, to control the slowdown etc. 
 
Major tools available with RBI to control inflation are Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Repo rate and Reserve Repo rate, Bank rate etc.
 
Cash Reserve Ratio (CRR) is that fraction of the total deposit with the commercial banks which they have to park with RBI. RBI uses CRR either to drain excess liquidity or to release funds needed for the growth of the economy from time to time. Increase in CRR means that banks have fewer funds available and money is sucked out of circulation.
 
Thus it serves dual purpose . First it ensures that a portion of bank deposits is kept with RBI and is totally risk-free, secondly, enables RBI to control liquidity in the system, and thereby, inflation by tying the hands of the banks in lending money.
 
SLR is Statutory Liquidity Ratio. It’s the percentage of Demand and Time Maturities  that banks need to have in any or combination of cash, gold valued at a price not exceeding the current market price and approved securities (G Secs or Gilts come under this) valued at a price as specified by the RBI from time to time. The maximum limit of SLR is 40% and minimum limit of SLR is 24%. It’s 24% now. This restriction is imposed by RBI on banks to make funds available to customers on demand as soon as possible. Gold and G Secs (or Gilts) are included along with cash because they are highly liquid and safe assets.
 
Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks against securities. When the repo rate increases borrowing from RBI becomes more expensive. 
 
It means that when RBI wants to make funds more expensive for the banks to borrow, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate. Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI.  
 
The banks use this tool when they feel that they are stuck with excess funds and are not able to invest anywhere for reasonable returns. An increase in the reverse repo rate means that the RBI is ready to borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep more and more surplus funds with RBI.
 
Thus, it can conclude that Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks
 
Bank rate is the rate at which RBI lends to the commercial banks for short term period. Bank rate along with SLR is most sparingly used by RBI.
 
Effect of change in interest rates
 
A change in repo rate has a direct impact in the interest rates offered to customers for loans by the same or by more magnitude. If saving rate is increased, person will get higher interest rate on his cash lying in the saving bank account, but it will affect the bank’s profitability.
 
However, interest rates also affect the common man indirectly through linkages. For instance, an increase in interest rate sucks the liquidity from the market and thus has negative impact on inflation which directly affects the common man. On the other hand, an increase in interest rate decreases the investment rate and thus adversely affects the growth and employment in the economy.
 
Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates.
 
Over a longer term, high interest rate would have more sector specific impact. The sectors which are most impacted by high interest rate is the real estate, automobile and all the capital intensive industries. Banking sector is likely to benefit most due to high interest rates. The Net Interest Margins (It is the difference between the interest they earn on the money they lend and the interest they pay to the depositors) for banks is likely to increase leading to growth in profits & the stock prices. If interest rate continues to rise for a longer duration then it will have an all round negative impact on the economy, leading it into a recessionary mode.
 
For a developing country like India, the right path would be maintaining a moderate inflation and interest rate over a period of time which keeps both the banks, business community and the consumers happy which is very crucial for the smooth running of the economy.  
 
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