RBI: Monetary Policy and Monetary Policy Committee, Important Terminology [Repo rate, MSF, LAF, Reverse repo rate ]
Headline : RBI takes offbeat tack to help reverse growth slowdown
- In its monetary policy review, the Monetary Policy Committee of the RBI has decided to cut the repo rate by 35 basis points (bps).
- In addition, the RBI also announced some measures to boost economic activity.
- Risk Weight: Risk weight is capital required to be set aside, stipulated by RBI for banks, or National Housing Bank for housing finance companies, that has to be made by banks for giving the loan.
- The bank or housing finance company has to keep aside money, based on the risk weight.
- A higher risk implies the bank will have to set aside a higher amount as loan provisioning. As a result, banks could be averse or less enthusiastic to lend to a particular sector.
- Real Interest Rate: The real interest rate is the difference between the repo rate and retail inflation.
- When making an investment decision, it is this interest rate that matters.
- The real interest rates in India have been rising, and that is one of the biggest reasons why investments are not happening.
- Repo Rate cut by 35 basis point: The Reserve Bank of India typically cuts or raise interest rates in increments of a quarter percentage point or multiples. However, this time, it has opted to break with convention by reducing the key policy rate, the repo rate, by 35 basis points (bps) to 5.4% .
- A 25 basis-point rate cut was deemed inadequate, while a 50 basis-point cut was excessive. That is why RBI took a balanced call.
- This would reduce the real interest rate and hopefully attract more investment.
- The move is also expected to revive demand to tackle a deepening economic slowdown.
- Note: With this rate cut, RBI has now reduced the repo rate by 110 bps in 2019.
- Reduction in risk weight for consumer loans: RBI has reduced the risk weight for consumer loans, except credit cards, from 125% to 100%.
- This move will encourage banks to extend loans to retail consumers segments such as individual vehicle loans and personal loans, amid a sharp slowdown in demand.
- Banks get more headroom for lending to NBFCs: The central bank has decided to increase the cap on a bank’s exposure to a single NBFC from 15% to 20% of its tier-I capital. Also, RBI has decided to give ‘priority sector’ tag for banks lending to NBFCs, for on-lending to farm, small and medium enterprises and housing sector.
- Banks have been allowed to lend to the NBFCs for on-lending to the agriculture sector up to Rs 10 lakh, up to Rs 20 lakh to micro and small enterprises, and for housing, up to Rs 20 lakh per borrower. These will be classified as priority sector lending.
- This will improve the available sources of funding, especially for new-age mid and small-sized NBFCs, at a relatively lower cost, while improving banks’ ability to meet their priority sector lending targets.
Why the interest rate for consumer loans has not reduced by 110 bps since February?
- To cover the earlier losses from non-performing assets (NPAs), the banks have to use their existing funds, which would have otherwise gone to common consumers for fresh loans.
- The reduced repo rate applies only to new borrowings of banks. The banks’ cost of existing funds is higher. Thus, the funding costs would take time to eventually come down.
- It could take anywhere between 9 and 18 months for the full effect of an RBI decision to reflect in interest rates across the economy.
In Focus: Monetary Policy and Monetary Policy Committee
Economic Activities in an economy:
- Private individuals and households spend money on consumption.
- The government spends on its agenda.
- Private sector businesses “invest” in their productive capacity.
- The net exports i.e. difference between what all of them spend on imports as against what they earn from exports.
About Monetary Policy
- For spending money, knowing cost of money is important and the central bank is mandated to decide the cost of money, which is more commonly known as the “interest rate” in the economy.
- Monetary policy is the macroeconomic policy laid down by the central bank.
- It is a set of economic policies that manages the size and growth rate of the money supply in an economy and regulates macroeconomic variables such as inflation and unemployment.
- Monetary policies are implemented through different tools, including the adjustment of the interest rates, purchase or sale of government securities, and changing the amount of cash circulating in the economy.
- In India, monetary policy of the Reserve Bank of India is aimed at managing the quantity of money in order to meet the requirements of different sectors of the economy and to increase the pace of economic growth.
What is Marginal Standing Facility (MSF) ?
- Marginal standing facility is a window for banks to borrow from Reserve Bank of India in emergency situation when inter-bank liquidity dries up completely.
- Banks borrow from the central bank by pledging government securities at a rate higher than the repo rate under liquidity adjustment facility or LAF in short
What is Liquidity Adjustment Facility (LAF) ?
- Reserve Bank of India’s liquidity adjustment facility of LAF helps banks to adjust their daily liquidity mismatches.
- LAF has two components: repo (repurchase agreement) and reverse repo.
- When banks need liquidity to meet its daily requirement, they borrow from RBI through repo. The rate at which they borrow fund is called the repo rate.
Reverse Repo Rate:
- When banks are flush with fund, they park with RBI through the reverse repo mechanism at reverse repo rate.
How does the RBI decide the interest rate?
- The RBI continuously maps prices, inflation (which is the rate of increase in prices), and expectations of inflation (of households) to decide if it should increase or decrease interest rates.
- For example: the RBI has marked inflation rate to be 4%. So, every time the retail inflation rate rises above the 4% mark, the RBI raises the cost of money i.e. the interest rate.
- When it does that, some people find it more advisable to put the cash out of the market and into banks. This way, inflation falls.
- The reverse process applies when the inflation is below the 4% mark.
- Also, to spur anaemic economic growth. The RBI cuts interest rates to incentivise people to consume more and businesses to invest more.
About Monetary Policy Committee in India
- On the recommendation of Urjit Patel Committee, Monetary Policy Committee was created in 2016 to bring transparency and accountability in fixing India’s Monetary Policy.
- The Monetary Policy Committee of India is responsible for fixing the benchmark interest rate in India, which was earlier decided by the Governor of Reserve Bank of India alone prior to the establishment of the committee.
- Three officials of the Reserve Bank of India (Governor of RBI: chairperson ex officio)
- Three external members nominated by the Government of India
- Decision: On the basis of majority with Governor having the casting vote in case of a tie.
- Meeting: At least 4 times a year and it publishes its decisions after each such meeting.
- The current mandate of the committee is to maintain 4% annual inflation until March 31, 2021 with an upper tolerance of 6% and a lower tolerance of 2%, while supporting growth.
- The committee is answerable to the Government of India if the inflation exceeds the range prescribed for three consecutive months