The announcement by the RBI that the repo rate in India will be lowered by 25 basis points from January 15, 2015 was welcoming news especially for the Indian industries. The overnight lending rate by the RBI to the banks will now be 7.75 percent. At last the Indian industries are hearing a sign of relief. This is a conversation between a student and his economics professor.
Student: Prof. Now the RBI has lowered the repo rate by 25 basis points will this be immediately passed on by the commercial banks to its customers?
Prof: As I said in the earlier blog, since each bank has its own flat rate, credit growth and availability, non-performing assets, target profits and administrative costs etc., it is not necessary that they will pass on the entire 25 basis points to the customer.
Student: What really is the motivation of RBI to lower the repo rate?
Prof.: India faces many economic challenges. For example, the factory output during April to December 2014 grew a measly by 2.2 percent. The RBI’s industrial outlook survey points to declining orders and raising inventories from the current and previous quarters. So this cut in interest rate could be a boom for automobile and housing sectors. If the banks decide to pass on the reduction, citizen will enjoy a lower EMI.
Student: What about the inflation rate?
Prof.: Thanks to the crude oil prices which have dropped from 120 US $ to 50 US $. The inflation rate in India is currently subdued. The CPI for December 14 was only 5 percent as against a target of 8 percent by the RBI for 2014 and 6 percent for 2015. Besides, the deflation in many countries is clearly pointing to a scenario of low inflation rate at least for the near term.
Student: Will the economy achieve a higher growth?
Prof.: This depends on a host of factors. Lowering interest rate does not necessarily imply that the economy will grow immediately. While the production may increase because of cheaper credit, it is not necessary that the consumer will rush to shops to buy goods. Even before that, we need to look at the state of affairs of the banks. According to some report the non-performing assets of banks is around 10 percent of the lendable funds. This has left them with stressed balance sheets and tight liquidity situation. How each bank will react to the drop in the repo rate is up to its management.
Student: What then are your concluding observations?
Prof.: For the rate cut to spur output, banks need to pass on the reduction. This is not something they have been wont to do. If RBI lowered its statutory liquidity ratio, may be more funds will be available with banks to lend. Banks face severe challenges. Their main priority will be to improve their balance sheets and increase their profits. They may use the RBI money to clean up their balance sheet by both reducing the liability and the assets.
Student: This is an extremely useful session for me. I learnt a lot of how the banks function in India. Thank you Prof.
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