ECONOMICS PROJECT

BANKING
RBI AND RATE CHANGES

DATE OF SUBMISSION – 03-04-2015

TO PROFESSOR DHIREN JOWANI

SEMESTER 2 (FIRST YEAR)

BBA-MBA FIVE YEARS INTEGERATED PROGRAM

Group No. –
Aayushi Srivastava (147102)
Aditi Bhardwaj (147104)
ChaitanyaKamdar (147111)
Manushi Sharma (147120)
Stuti Bhandari (147153)
 Index

ABSTRACT
INTRODUCTION
LITERATURE REVIEW
DATA ANALYSIS
CONCLUSION
 Abstract

We were given the topic of banking sector. It can be considered as a system

provided by the bank which offers cash management services for customers,
reporting the transactions of their accounts and portfolios, throughout the day.

Now the question arises is, what is the significance of this sector in the development
of Indian economy?

Banking system in any country deals with all the financial transactions and matters of
an economy. It is responsible for the formulation of monetary and fiscal policies
which in turn affects the growth and development of the nation.

Repo rates and reverse repo rates are one of the major tools for controlling monetary
transactions and credit in the economy. It is the function of Reserve Bank of India to
control and regulate credit in India. It manipulates these rates to look after inflation,
money supply, exchange rates, etc.

In this report we have done a research over the last ten changes in repo and reverse
rates undertaken by RBI, reasons for its change in a broad context, its impact on the
economy and its relation with several factors like inflation.
 INTRODUCTION
CRR

The Reserve Bank of India (Amendment) Bill, 2006 has been enacted and has come into force with
its gazette notification. Consequent upon amendment to sub-Section 42(1), the Reserve Bank,
having regard to the needs of securing the monetary stability in the country, RBI can prescribe
Cash Reserve Ratio (CRR) for scheduled banks without any floor rate or ceiling rate.  [Before the
enactment of this amendment, in terms of Section 42(1) of the RBI Act, the Reserve Bank could
prescribe CRR for scheduled banks between 3 per cent and 20 per cent of total of their demand
and time liabilities].

Banks in India are required to hold a certain proportion of their deposits in the form of cash. 
However, actually Banks don’t hold these as cash with themselves, but deposit such case with
Reserve Bank of India (RBI) / currency chests, which is considered as equivalent to holding cash with
RBI. This minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by the
RBI and is known as the CRR or Cash Reserve Ratio.  Thus, when a bank’s deposits increase by Rs100,
and if the cash reserve ratio is 6%, the banks will have to hold additional Rs 6 with RBI and Bank will
be able to use only Rs 94 for investments and lending / credit purpose. Therefore, higher the ratio
(i.e. CRR), the lower is the amount that banks will be able to use for lending and investment.  This
power of RBI to reduce the lendable amount by increasing the CRR makes it an instrument in the
hands of a central bank through which it can control the amount that banks lend.  Thus, it is a tool
used by RBI to control liquidity in the banking system.

SLR

Every bank is required to maintain at the close of business every day, a minimum proportion of
their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and un-
encumbered approved securities. The ratio of liquid assets to demand and time liabilities is known
as Statutory Liquidity Ratio (SLR).  RBI is empowered to increase this ratio up to 40%. 

This indicates the minimum percentage of deposits that the bank has to maintain in form of gold,
cash or other approved securities.  Thus, we can say that it is ratio of cash and some other approved
securities to liabilities (deposits) it regulates the credit growth in India. 

Bank Rate

Bank Rate is the rate at which central bank of the country  (in India it is RBI) allows finance to
commercial banks. Bank Rate is a tool, which central bank uses for short-term purposes. Any upward
revision in Bank Rate by central bank is an indication that banks should also increase deposit rates as
well as Base Rate / Benchmark Prime Lending Rate.  Thus any revision in the Bank rate indicates that
it is likely that interest rates on your deposits are likely to either go up or go down, and it can also
indicate an increase or decrease in your EMI.
REPO RATE AND REVERSE REPO RATE

Repo Rate or the Repurchase Rate is the rate of interest at which RBI lends or advances a certain
amount of money to the Commercial Banks for short time periods against Government Bonds.

Reverse repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of
India) borrows money from commercial banks within the country.

They both are important monetary measures of RBI to control inflation. In case of inflation, RBI will
try to reduce the amount of money in circulation by increasing the repo Rate. When repo rates are
increased, banks will borrow less from RBI and hence the amount of money they will be lending to
the public also decrease. When the RBI signals a rate increase, it gives a direct signal to the banks
that there is too much credit flowing in the system and that they should not fall below reserve
requirements or else the cost of raising capital from the RBI would be higher. This limits the Bank's
ability to pump money into the system via loans i.e. credit. Here the cost of raising capital is the cost
of money which is the future payments that banks have to make for borrowing today. If the rates are
higher, then it automatically means that in the future Banks will have to make higher payments and
therefore the Banks would not pump money into the system because it would mean going to the RBI
for funds which would cost more. Increase in repo rate can have serious impact on the growth since
industries will find it difficult to raise money from the banks. Therefore bank rates are only increased
when rate of inflation become too high and that too only for a short period.

In case of a deflation, RBI will want to inject more money into circulation and hence they will reduce
the repo rate.when the RBI signals a rate decrease, it is a signal to the banks that they can pump
money into the system because it would now be easier to raise money from the RBI. Even if the
Banks fall below the reserve requirements, they can raise money from the RBI at cheaper rates.

Reverse Report rate was an independent rate till 03/05/2011.  However, in the monetary policy
announced on 03/05/2011, RBI has decided that now onwards the Reverse Repo Rate will not be
announced separately, but will be linked to Repo rate and it will always be 100 bps below the Repo
rate.

This was due to LAF policy.

Now, WHAT IS LAF?

LAF (liquidity adjustment facility) is used to aid banks in adjusting the day to day mismatches in
liquidity. LAF consists of repo and reverse repo operations. Repo operations therefore inject liquidity
into the system. Reverse repo operation therefore absorbs the liquidity in the system. The collateral
used for repo and reverse repo operations are Government of India securities.

Liquidity adjustment facility has emerged as the principal operating instrument for modulating short
term liquidity in the economy. Repo rate has become the key policy rate which signals the monetary
policy stance of the economy.
 IMPACT OF MONETORY POLICIES

Monetary policy thus has an effect on the interest rates the general public face and thereby also on
the total demand and total supply in the economy. The channels that mean that market interest
rates affect supply and demand can be divided into the interest rate channel, the credit channel and
the exchange rate channel. You can read more about these channels below.

 
Credit channel
The credit channel describes the way in which monetary policy affects demand via banks and other
financial institutions. If the interest rate rises, banks choose to decrease their lending and instead
buy bonds. This means that households and companies find it more difficult to borrow money.
Companies that are either unable or unwilling to borrow must cut back their activities, postpone
investment and so on, and this dampens activity in the economy.  

 
Interest rate channel
- The interest rate channel affects the demand for goods and services. Higher interest
rates normally lead to a reduction in household consumption. This happens for
several reasons. Higher interest rates make it more attractive to save, in other words
to postpone consumption, thus lowering present consumption. Consumption also
falls because existing loans now cost more in terms of interest payments. Finally,
higher interest rates mean that the price of both financial and real assets - shares,
bonds, property, etc. - falls in that the present value of future returns drops when
interest rates rise. When faced with dwindling wealth, households become less
willing to consume.
- A rise in interest rates also makes it more expensive for firms to finance
investment. As a result, higher interest rates normally curtail investment. If
consumption and investment fall, so does aggregate demand. 
 - Lower aggregate demand results in lower resource utilization. When resource
utilization is low, prices and wages usually rise at a more modest rate. However, it
takes time before a decline in resource utilization leads to a fall in inflation. This is
partly because wages do not change from month to month but more seldom than
that.
Exchange rate channel
- The exchange rate channel describes how monetary policy affects the value of the
currency. Normally, an increase in the repo rate leads to a strengthening of the
Rupee. In the short term, this is because higher interest rates makes domestic assets
more attractive than investments denominated in other currencies. The result is a
capital inflow and increased demand for kronor, which strengthens the exchange
rate.
- Monetary policy also plays an important part for the exchange rate in the long term.
By definition, the exchange rate is the price of a country’s currency expressed in
terms of another country’s currency, which means that it is affected by differences in
inflation between countries. Tighter monetary policy means lower inflation, which in
the long run can be expected to be reflected in a stronger exchange rate. 

Review of literature
ANALYSIS OF LAST 10 REPO RATES AND REVERSE REPO RATES
25th OCTOBER 2011

The Reserve Bank of India (RBI) raised repo and reverse repo rates from 8.25% to 8.5%
and 7.25% to 7.5% on 25th October 2011 to arrest rising inflation in India.

Inflation:
Inflation, which had been the major reason behind the RBI aggressive stance, had remained
above 9 percent for 10 straight months. Food inflation climbed to 10.60% during the same
month.
The RBI's rate hikes had helped to some extent in the moderation of inflation, but the
inflation rate was still in an uncomfortable zone going by the RBI's mandated range for
inflation.
“India's end-March headline inflation is seen lower than 8% and prices are expected to
soften from December, Deputy Chairman of the Planning Commission Montek Singh
Ahluwalia had said which did not happen later.”

Slowdown in growth rate:

Data and Reports indicated that India's GDP growth rate had moderated due to the high
interest rate regime adopted by the RBI. The GDP growth had been revised downwards to
around 8 percent for that current fiscal as against the earlier projected number of around 9
percent.
It was considerable as slower economic growth rate is acceptable in the short-term,
provided it reduces the inflationary pressures. However, the steps taken by the RBI had not
yielded the expected results which were an area of concern. On the other hand, the
measures had started slowing down the economic growth rate.
On a macro level, a weaker currency had made the war against inflation tougher.

Market Impact:
If RBI had decided to hike more than 25 bps, it might have affected the stock market very
negatively. Unrelenting inflation, despite consistent rate hikes, had shattered hopes of the
interest rate cycle coming to an end soon and amidst uncertainty over how soon the rate
cycle will peak out, most brokers predicted a weak outlook for rate-sensitive realty, banking
and automobile shares.

Reverse Repo Rates:

As it is known reverse repo rates are always 1% less than repo rates and were hiked for
major reason of decreasing money supply in markets.

17 APRIL 2012
Finally it was out of box decision by the former RBI Governor D. Subbarao as it was first
rate cut by RBI during the previous 3 years from that time.The repo rate had been reduced
from 8.5% to 8%. Consequently, the reverse repo rate had been reduced from 7.5% to 7%. 

Inflation:
After hiking policy rates for 13 consecutive times between March 2010 and October 2011, the
regulator had taken a pause to support India’s falling growth momentum. On April 21, 2009 RBI had
last reduced its key policy rates by 25 basis points. The rate cut move came as a surprise as the
market was expecting only 25 bps reduction in the policy rate. RBI was now tilting towards growth
from its strict anti-inflationary stance after a series of rate cuts to stem the rising rate of inflation.
Consequently, the rate of inflation eased to 6.9% in March from 10% during the fiscal year. The
average inflation rate in India was 7.99% between 1969 and 2010.

Slowdown in growth rate:

The reduction in the repo rate at which RBI lends to banks, had been prompted by deceleration in
growth and softening of inflation.The cut had been aimed at spurring growth to 9 per cent levels,
seen before the global financial crisis that had begun in 2008.

"The reduction in the repo rate is based on an assessment of growth having slowed below its post-
crisis trend rate, which, in turn, is contributing to the moderation in core inflation," the Governor
said.

29 JANUARY 2013

RBI Governor D Subbarao in the third quarter monetary policy review surprised the market by
cutting short-term lending rate called repo by 0.25 per cent to 7.75 per cent.

The growth projections had been reduced for the current financial year to 5.5 per cent from its
earlier estimate of 5.8 per cent.

On inflation, it had been moderated the rate to 6.8 per cent for March-end from earlier projection of
7.5 per cent.

Stock market celebrated the rate cut with a 91 point rally in early trade.

"The moderation in inflation conditions provides the opportunity for monetary policy to act
in conjunction with fiscal and other measures to stem growth risks," Subbarao said.

19 March 2013

Based on an assessment of the current macroeconomic situation, RBI decides to reduce

the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis points from
7.75 per cent to 7.5% with immediate effect; consequently, the reverse repo rate under
the LAF stands adjusted to 6.5%.

Notwithstanding moderation in non-food manufactured products inflation, headline

inflation was expected to be range-bound around levels of 2013-14 in view of sectoral
demand-supply imbalances, theprevailing corrections in administered prices and their
second-round effects. In addition, elevated food prices, including pressures stemming from
Minimum Support Price increased, and the wedge between wholesale and retail inflation
had adverse implications for inflation expectations.

“RBI will continue to actively manage liquidity through various instruments, so as to ensure
adequate flow of credit to productive sectors of the economy”, said RBI Governor.

3 May 2013

On the basis of the current assessment and in line with policy stance outlined in Section
III, the Reserve Bank announces Repo Rate had been reduced, under the liquidity
adjustment facility (LAF) by 25 basis points from 7.5 per cent to 7.25 per cent with
immediate effect. The RBI trimmed the repo rate to 7.25%, it’s lowest since May
2011.Reverse Repo Rate under the LAF, determined with a spread of 100 basis points
below the repo rate, stands adjusted to 6.25 per cent with immediate effect.

DOMESTIC ECONOMY – A VIEW

This was the time when monetary policy statement was given by the RBI chief D.V Subbarao.
Indian economy was going through a declining phase and thus, the annual policy was
formulated to stabilise the economy and with the prospects of turnaround. Domestically,
growth slowed much more than anticipated. Most lead indicators suggest a slow recovery
through 2013-14. Inflation eased significantly but upside pressures remain, both at
wholesale and retail levels, stemming from elevated food inflation and ongoing
administered fuel price revisions.

Against this backdrop, the stance of monetary change was intended to:

1. Continue to address the accentuated risks to growth.

2. Guard against the risks of inflation pressures re-emerging and adversely impacting
inflation expectations, even as corrections in administered prices release suppressed
inflation.
3. Appropriately manage liquidity to ensure adequate credit flow to the productive
sectors of the economy.

20 September 2013

RBI hikes repo rate to 7.5% and reverse repo rate to 6.5%
The two sets of measures constitute a delicate balancing act, as the new governor attempted to
redouble India’s fight against fast-rising prices while also providing relief to the nation’s struggling
banking system by easing recently imposed liquidity restrictions.

But Governor justified his unexpectedly tough stance by arguing that the combined impact
of the twin changes could help to revive growth, by providing a reduction in the cost of
funding for commercial banks.

India’s stock markets fell by around 2 per cent following the RBI’s announcement, while the
rupee lost just less than 1 per cent against the US dollar.

Industrialists and business groups were predictably critical of the rate increase, which they
had said would suppress investment and further damage economic growth.

“This is an unwise move, and I don’t know why he has sided with the hawks and given
growth no chance at all,” said Rajiv Kumar, an economist and a former secretary-general of
the Federation of Indian Chambers of Commerce and Industry.

29 October 2013

The Reserve Bank of India raised interest rates for the second time in as many months on Tuesday,
warning that inflation is likely to remain elevated despite sluggish growth, and rolled back an
emergency measure put in place in July to support the rupee. Facing some of the fiercest price
pressures in Asia, the RBI lifted its policy repo rate by 25 basis points (bps) to 7.75 percent, in line
with expectations in a Reuter’s poll.

With the rupee having stabilised after a steep May-August slide, the RBI also lowered its Marginal
Standing Facility (MSF) rate by a further 25 bps to 8.75 percent, which eased liquidity in the banking
system by lowering the cost of borrowing for lenders. India's benchmark 10-year bond yield had
dropped as much as 12 bps to 8.54 percent, as traders were relieved that the rate hike was
accompanied by an MSF cut.

The RBI had expected the economy to grow 5 percent in that current fiscal year that ended in March,
below its earlier forecast of around 5.5 percent but still above many private-sector forecasts.

"You should not see the fight against inflation as anti-growth. It is going to be the best medicine for
sustainable growth going forward," Rajan told a media briefing.

"The pass-through of rupee depreciation into prices of manufactured products is acting, along with
elevated food and fuel inflation, to offset possible disinflationary effects of low growth," Rajan said in
his policy statement.

28 January 2014
The RBI surprisingly raised interest rates on Tuesday to dampen inflation, saying it was now better
prepared to deal with the risk of major capital outflows roiling emerging economies.The repo rate,
at which banks borrow short-term money from RBI, was raised by 25 basis points, or 0.25
percentage point, to 8 per cent. The reverse repo, at which RBI borrows from banks, was raised 25
basis points to 7 per cent.

The Reserve Bank of India (RBI), however, said that if retail inflation eases as projected, it does not
foresee further near-term monetary policy tightening.

The Indian economy, which not long ago was aspired to double-digit growth, had been weakened by
sluggish investmentand persistent inflation in recent years.Most economists in a Reuter’s poll last
week had expected no change in rates. However, expectations for a rate hike had increased after a
central bank panel proposed to make CPI the main inflation benchmark.

"For now, this should mark the peak of the rate hike cycle, with the central bank's growth projections
close to our conservative estimates," said Radhika Rao, economist at DBS Bank in Singapore.

The RBI said economic growth was likely to fall short of its earlier projection of 5 percent this fiscal
year and improve to 5-6 percent in the year that starts in April.

15 January 2015

RBI in its bi-monthly monetary policy statement cut its main lending rate (Repo Rate) by
0.25 per cent with immediate effect. This is the first rate cut from the RBI since 2013. With
this, repo rate and reverse repo rates will now prevail at 7.75% and 6.75% rates from
previous 8% and 7% respectively.

These rates cuts were necessitated because:

1. Inflationary pressures (measured by changes in the consumer price index) had been easing,
since July 2014.
2. The path of inflation, while below the expected trajectory, had been consistent.
3. Inflation had been lower than expected due to sharp decline in prices of vegetables and
fruits since September 2014 and receded pressures in respect of cereals and the large fall in
international commodity prices, particularly crude oil.
4. It seemed that the crude price is expected to remain low over the year due to geopolitical
shocks.

04 March 2015
RBI has (4.3.2015) surprised the Indian Economy by reducing the Repo Rate by 25 basis points
from 7.75% to 7.5%. Consequently, the reverse Repo Rate will be 6.5%.

This showed that RBI and Government are working towards Policy frame work of Government of
India and also RBI's faith in the budgetary proposals of the Government for fiscal consolidation and
to control inflation.

The RBI and Government has common objectives in terms of a Memorandum for targeting inflation
in the next coming years which will also enable the Government and RBI to implement fiscal and
Monetary Policy for their common objective.

The Government has understood that the low capacity utilization and weak indicators of production
has to be addressed and RBI responded by lowering the Repo Rate which benefit Trade and Industry
with may lower cost of capital.

Reason-

1. Very reasonable and moderate fiscal projections done by the Government.

2. Rupee remained little strong when compared with other currencies.
3. Fall in energy prices.
4. The larger share of the revenue going to States will reduce their deficit which will control
over all fiscal deficits.
5. The cut in the policy rate will also help in lowering interest rate for individual and corporate
borrowers and will also make home, auto loans cheaper.

Sources: RBI Press Releases and Business dailies .

 Data Analysis

Date Inflation (WPI) Repo rates Reverse repo rates

25-10-11 9.9 8.5 7.5
17-04-12 7.5 8 7
29-01-13 7.3 7.75 6.75
19-03-13 5.6 7.5 6.5
03-05-13 4.5 7.25 6.25
20-09-13 6 7.5 6.5
29-10-13 7.25 7.75 6.75
28-01-14 5.1 8 7
15-01-15 -0.39 7.75 6.75
04-03-15 -2.06 7.5 6.5

Line Graph

Inflation, Repo & Reverse Repo rates

12
10
8
6
4
2
0
25/10/2011 17/04/2012 29/01/2013 19/03/2013 03/05/2013 20/09/2013 29/10/2013 28/01/2014 15/01/2015 04/03/2015
-2
-4

Inflation (WPI) Repo rates Reverse repo rates

Correlation between Inflation and Repo Rate’s last ten changes: 0.50895 and between Inflation
and Reverse Repo Rate’s last ten changes: 0.508950344.

The figures of both correlations are almost same because growth in repo and reverse repo rates
are done together and in same direction.
 Conclusion

RBI, in order to control the financial mechanism of the economy uses this as
a tool to conduct its monetary operations which involve monetary techniques
operating on monetary magnitudes such as money supply, interest rates and
availability of credit aimed to maintain PriceStability, Stable exchange rate,
Healthy Balance of Payment, Financial stability, Economic growth.

Changes in repo and reverse repo rate go hand in hand as a part of liquidity
adjustment facility. These changes are generally undertaken to bring the
desired growth in the economy.

2012 and 2013 was that phase in Indian economy in which it started
experiencing severe sluggishness in terms of GDP, foreign exchange,
exchange rates, inflation, etc. this was the major reason behind frequent
changes in these rates by RBI. Although, there were some instances where
changes were sudden and unexpected.

In 2014 due to formation of a stable government, Indian economy was

expected to grow with accelerating pace. But the economy required some
more time to be back on track. Mr. Raghuram Rajan, thus increased the rates
again looking at the inflationary pressures still persisting in the economy.

In 2015, the ray of hope had started showing its effect. Inflationary pressures
were easing and growth rate was increasing, more government expenditure
on infrastructure, exchange rates were in control and there was then a sudden
rate cut by RBI. This was the first rate cut since 2013.

The RBI revises repo rates in their quarterly and mid-quarter policy reviews to
maintain a balance between growth and inflation. The past two years have
been proof of this practice as the apex bank tried to first tame the monster of
inflation with aggressive rate hikes, and once it saw growth taking a hit,
reduced key rates to revive the economy.