The Effects of Interest Rate Changes by Reserve Bank of India

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Introduction The Indian economy is based

The Indian economy is based upon two pillars. The first one is the Monetary policy controlled by the Central Bank of the country i.e. Reserve Bank of India and the second one is Fiscal Policy, formulated and adopted by the Ministry of Finance, Government of India. Monetary policy is the process or actions taken by RBI or the other monetary authority of the country to achieve macroeconomic policy objectives such as price stability, full employment, optimum production and consumption and stable economic growth and liquidity. Monetary policy can be expansionary and contractionary in nature. Increasing money supply and reducing interest rates indicate an expansionary policy. The reverse of this is a contractionary monetary policy. With the help of Bi-Monthly Monetary Policies instruments the central bank can control the economy. The major objectives that are achieved by the RBI with its policies

The major objectives that are achieved by the RBI with its policies are:
1. Price Stability and Controlling inflation Price stability comes from reasonable rate of inflation. It implies promoting economic development with considerable emphasis on price stability. RBI tries to achieve this target keeping control over money supply in the market. A high degree of inflation has adverse effects on the economy. 2. Encourage Economic Growth Monetary policy can promote economic growth through ensuring adequate availability of credit at a lower cost of credit.
3. Stability in Exchange Rate The changes in capital inflows and outflows and changes in demand for and supply of foreign exchange, particularly US dollar, arising out of foreign trade causes great influence in foreign exchange rate of rupee.
4. Control Over Expansion of Bank Credit The RBI acts as a controller for expansion of bank credit. The various Instruments used by Reserve Bank of India to control over the financial condition of the Economy through monetary policy are ----- A) Changes in the Supply of Currency ( However it is a part of Fiscal Policy Matter) B) Quantitative Measures : i) Variations in Bank Rates ii) Open Market Operations iii) Variations in Reserve Ratios C) Qualitative Measures : i) Moral Persuasions ii) Punitive Actions iii) Encouraging Hire Purchase/Installment Payment System of Trade D) Selective Credit Controls

Objective of the Paper

The RBI, while publishing their Bi-monthly monetary policies in the current financial year has experienced enormous pressure from the Government of India to cut down interest rate for Bank Credit. This is obviously a resultant effect of persuasions made by various industrial houses and big corporate on the Government. The government however, is committed to economic development through reforms and a situation of controlled - inflation is high time for adopting such measure. But this decision may cause a massive effect in various segments in the economy. The Paper is trying to evaluate various after effects of such decision of reducing interest rates. Whether the decision is feasible for the mass or not. In India if the RBI changes their interest rates through the Repo and Reverse Repo rates the effects will show into the various economic and financial sectors. Here we can divide it in four different segments like Growth, Inflation, Liquidity and Industry or Trade.

Backdrops and Effects of Changing Interest Rate by RBI:
1. Agricultural and Industrial Growth:

Before publication of 1st Bi-Monthly Monetary Policy on April 2015
(Holding Repo at 7.5% and Reverse Repo at 6.5%)

  • Agricultural Growth: the agricultural growth in the economy was satisfactory and it was supported by the primary and secondary sectors of the economy as the production of food and other agricultural products were much better than a gloomy picture shown at the beginning of the year. The ultimate growth was increased by approx. 1.5% on 2015 Fiscal over 2014. So RBI holds their Repo and Reverse Repo rate in their 1st issue.
  • Industrial Growth: Likewise agricultural growth, the Industrial growth for the last three consecutive months yielded a revival or development in the manufacturing and trading industry.

    Before publication of 2 nd Bi-Monthly Monetary Policy on June 2015
    (Reducing Repo at 7.25% as well as Reverse Repo at 6.25%)

 

  • Agricultural Growth: As compared to the 1st quarter of 2015, Rabi Crop faced extensive damage in March 2015 due to scanty and uneven rainfall. However, it was forecasted by IMD and there was an opportunity for producing alternative Kharif Crop to cover up the shortage. To cope up with this situation, RBI reduced the Repo as well as the Reverse Repo Rate on June 2015
  • Industrial Growth: in the Fiscal year of 2014, the Industrial Growth was not significant. To reverse the situation and to revive the industrial growth, RBI reduced Repo and Reverse Repo rates for encouragement of Industrial Modernization.

    Before publication of 3 rd Bi-Monthly Monetary Policy on August 2015 (Holding Repo at 7.25% as well as Reverse Repo at 6.25%)

  • Agricultural Growth: In the last issue as there were both unchanged massive effect of weak monsoon, RBI reduced the interest rates to take a stock of the adverse situation. The effect continued and therefore no changes has made.
  • Industrial Growth: The decision taken in the previous issue for reduction of Repo and Reverse Repo rates the industrial sector has shown a growth and it was sustained. So the rates remain unchanged.

    2.Consumer Price Index (CPI) Inflation: 



  • As an instrument of Monetary Policy the interest rates fixed by RBI makes a significant impact on the Consumer Price Index inflation rate. The index which indicates changes in the price level of market of consumer goods and services purchased by households. So the paper is trying to show the impacts of interest rate i.e. the Repo and Reverse Repo rates on the CPI.

    Before publication of 1st Bi-Monthly Monetary Policy on April 2015

    (Holding Repo at 7.5% and Reverse Repo at 6.5%)

    The Central Bank strived towards following the “Disinflationary Glide Path” put forward by the Patel Committee report on Dec 2013. The CPI inflation was maintained as per the forecast as of Feb ’15 at 5.3% despite the reversal of the high base effect, on the other hand, the Wholesale Price Index inflation entered negative territory at -2.1% in Feb ’15.

    Before publication of 2 nd Bi-Monthly Monetary Policy on June 2015

    (Reducing Repo at 7.25% as well as Reverse Repo at 6.25%)

    The estimation of the CPI inflation made by RBI 3 months before was right and as a result of holding Repo and reverse Repo rates, the CPI inflation came in well at 4.87%. Whereas, the Wholesale Price Index inflation rose marginally in the month of April ’15.

    Before publication of 3 rd Bi-Monthly Monetary Policy on August 2015

    (Holding Repo at 7.25% as well as Reverse Repo at 6.25%)

    As in 2015, there was an uneven, monsoon, so the supply of food and vegetables were decreased and resulted unfavourable movements of inflation before August 2015. Steady rise in food and non food prices was notified by a hike in vegetables, pulses and spices

    3. Liquidity:

    Before publication of 1st Bi-Monthly Monetary Policy on April 2015
    (Holding Repo at 7.5% and Reverse Repo at 6.5%)

    RBI carried out liquidity management well through various term Repo auctions and sufficient liquidity was maintained.

    Before publication of 2 nd Bi-Monthly Monetary Policy on June 2015 (Reducing Repo at 7.25% as well as Reverse Repo at 6.25%)

There was a crunch in March 2015 which was revived to smooth in April 2015. It was strained again in May 2015 on account of a buildup in currency in circulation and build-up of government balances. RBI conducted term repos of various tenures along with the regular overnight repo and 14-day term repo auctions.

Before publication of 3 rd Bi-Monthly Monetary Policy on August 2015

(Holding Repo at 7.25% as well as Reverse Repo at 6.25%)
The reduction of Repo in June 2015 was successful for carrying Liquidity conditions in JuneJuly as there was seasonal reduction in demand for currency and high government spending kept the money markets in surplus. In this favourable condition of liquidity, the call money rate remained lower than the repo rate throughout July 2015. 4. Trade and Industry: Before publication of 1st Bi-Monthly Monetary Policy on April 2015 (Holding Repo at 7.5% and Reverse Repo at 6.5%) At the end of 2014, the Trade and Industrial growth was very low due to contraction of exports and imports. Exports

4. Trade and Industry:

Before publication of 1st Bi-Monthly Monetary Policy on April 2015

(Holding Repo at 7.5% and Reverse Repo at 6.5%) At the end of 2014, the Trade and Industrial growth was very low due to contraction of exports and imports. Exports was reduced due to weak global demand, on the other hand due to decrease in oil price the value of imports was also reduced. Hence, the Trade Deficient was somehow neutralized. Though FII inflows remained negative, increased FDI and deposits from non-residents remained steady.

Before publication of 2 nd Bi-Monthly Monetary Policy on June 2015
(Reducing Repo at 7.25% as well as Reverse Repo at 6.25%) The declining trend of exports continues

The declining trend of exports continues till June and July and also there was a pressure of negative growth rate. FII inflows ended at $ 41 billion in FY15 and it was drifted into the negative space from May ’15. Lastly, strong foreign exchange reserves of around $350 billion provided cushion to any external shock.

Before publication of 3 rd Bi-Monthly Monetary Policy on August 2015
(Holding Repo at 7.25% as well as Reverse Repo at 6.25%)

The INR was getting stronger vis-à-vis the USD which has impacted the country’s export margins. However the export of Indian Software Service and Travel contributed towards a lower Current Account Balance of 1.6% of GDP in Q3 FY15. Foreign Exchange Reserve of the country enhanced by foreign inflow towards our equity, debt securities and FDI.

5. Banking Business: Reduction of interest rate on lending adversely affects the yield on advances of Banks. Cost of establishment and other overheads are more or less constant or increasing in nature. So, to maintain profit margin banks are forced to reduce cost of funds, by reducing interest rates on deposits. Due to high competition among each other as also possibility of losing business, banks cannot match the rate of reduction on both sides. The resultant effect comes on their profit. Lower interest rate on deposit discourages propensity to save and thus inflationary situation arises.

Future Prospect and Conclusion

After a pro long disagreement between RBI and the Central Government in the matter of interest rates, Dr. Raghuram Govind Rajan, the Governor of RBI announced at August last indicating a reduction in future economy of India. The Central Government and the industry creates pressure on RBI to reduce or cut down the interest rate to decrease the cost of capital which will increase the growth rate up to 8%-9% and also there are other macroeconomic factors existence like the controlled interest rate. After cutting down the interest rate thrice during the year as RBI is still in “Accommodative Mode” so they thinks about for reduction of interest rate again in their upcoming publication of monetary policy on October 2015. As per Dr. Rajan India was a big trading partner on China, but still the impact of any slowdown in the Chinese Economy may not as big as some other countries. RBI also advised the US Federal Reserve against raising the rates when the world economy was in turmoil. RBI had reached an agreement with the government on the new panel for setting rates, the Monetary Policy Committee where the government can appoint majority of the members on the panel to be chaired by the Governor, while a veto power earlier proposed to be vested with the Chairman was also sought to be withdrawn.

Posted by: Arkaprava Chakrabarty. in Finance | Date: 29/02/2016

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