Cash Reserve Ratio (CRR) & it’s Impact

Cash Reserve Ratio is that portion of banks total deposits which Banks have to park with Central Bank (RBI in India). A bank earns its income through lending at higher rates and paying low rate of interest on Deposits.
So any increase in CRR leads to lesser amount of money at disposal of banks, which can be given as advances and loans, thereby sucking liquidity in market. On the other hand, a decrease in CRR implies more money at disposal of banks, and hence more liquidity in market.
Increase in CRR means lesser liquidity, which in turn leads, to higher interest rates, implying fewer new projects, more interest costs for companies and individuals on their outstanding portion of loans (if taken on variable or market linked rate of interest), less spending on luxuries, lesser investments opportunities, etc. this will cause lesser demand and hence prices will come down (i.e. inflation rate will come down).

Thus, an increase in the CRR leads to banks being forced to keep more money with RBI reducing the funds available for lending. As less money is available to the bank to lend there is bias towards increase in rates as per the normal laws of supply and demand. So an increase in CRR will normally result in an increase in interest rates (and vice versa a reduction in CRR will normally result in a reduction in interest rates).

Let us say the RBI increase the CRR. This would mean that banks would have to keep more money with the RBI. This, in turn, would reduce the money available with them, thus bringing down the money supply in the market. A lower money supply would lead to an increase in interest rates.

Over the years CRR has become an important and effective tool for directly regulating the lending capacity of banks and controlling the money supply in the economy. When the RBI feels that the money supply is increasing and causing an upward pressure on inflation, the RBI has the option of increasing the CRR thereby reducing the deposits available with banks to make loans and hence reducing the money supply and inflation.
Now look at the other side. A reduction in CRR would put more money in the coffers of the banks. As the money supply rises, interest rates decrease.

While the availability of Cash Reserves provides numerous benefits to society and the economy, it also poses a serious drawback in the form of lost interest. Banks do not earn interest on cash reserves, which results in reduced earnings for the bank and for its customers. In a 1992 release, the Federal Reserve estimated this loss to exceed $700 million per year in pre-tax earnings, which represents a loss of roughly 2 percent.

What do we do when interest rates are high?

Well, common sense would dictate that when the interest rates are high, we save, and not spend, money.

On the other hand, lower interest rates act as a disincentive to save money. So, in this case we would spend, and save.

Lower interest rates often boost demand for goods and services. In the short run, this would result in inflation as supply may not be able to match demand. Currently, to control the steeply rising inflation, the RBI twice raised the CRR in the recent past.

The reason why the RBI controls the CRR is that it is an effective and important tool to control inflation.

To put in a nutshell, a higher CRR would mean that there is less money available in the market. So there will be less money with people. This would mean that their demand for goods and services would be low. So the prices would be low.

Let’s make the entire concept, more Understandable, citing an example from routine life. When you deposit Rupees 100, in a Bank, it gets Rupees 100 & now it can use this Rs 100, to lend others, but they have to put some part of it (as per CRR: say it to be 8%), with RBI, i.e. Rupees 8 with RBI, in this case & they are left with Rs 92, to lend to others.

From the perspective of a borrower

As a prospective borrower, you are the worst hit. The cost of money i.e. interest rates will rise post the CRR hike. You will probably need to settle in for a lower loan amount given the EMI. If you are an existing borrower, as long as the rate of interest on your loan is fixed, you are immune to any rise in interest rates. However, if you have a floating rate loan, then expect either the tenure of the loan or the EMI to jump soon.

Repo & Reverse Repo Rate & its Impact

bps : It is an acronym for basis point and is used to indicate changes in rate of interest and other financial instruments. 1 basis point is equal to 0.01%. So when we say that repo rate has been increased by 25 bps, it means that the rate has been increased by 0.25%.

Repo Rate and Bank Rate

People often get confused between these two terms. Though they appear similar there is a basic difference between them.

Repo rate or repurchase rate is the rate at which banks borrow money from the central bank (read RBI for India) for short period by selling their securities (financial assets) to the central bank with an agreement to repurchase it at a future date at predetermined price. It is similar to borrowing money from a money-lender by selling him something, and later buying it back at a pre-fixed price.

Bank rate is the rate at which banks borrow money from the central bank without any sale of securities. It is generally for a longer period of time. This is similar to borrowing money from someone and paying interest on that amount.

Both these rates are determined by the central bank of the country (RBI in Indian Banking Context) based on the demand and supply of money in the economy.

Repo rate is basically the rate charged on this thing called a repo or “repurchase agreement”. Essentially, a repurchase agreement is an agreement between one party and another in which the former sells a security (like a bond) to the latter with a promise to buy it back after a particular period.

When we take a loan from any bank, we pay Interest for that. In the same way, Banks also take short-term loans from Central Federal Bank (RBI in Indian Context) & RBI charges the Interest at the rate, which is well-known as Repo Rate.

For instance, a bank may enter into a repo with RBI, selling a security to RBI and then telling RBI, that I will buy this security back from you after 3-months.

RBI tells the bank…OK I will pay Rs. 100 for this security now but when you buy it back from me, please pay me Rs. 103. The extra Rs. 3 that RBI charges constitutes the repo rate (translates into 12% pa for this example).

Hence, repos are a form of “collaterlised or secured borrowings” in which the borrower must place a collateral with the lender (in this case RBI). If the borrower does not manage to buy back the security, the lender can redeem its collateral value. Generally, repos are used for managing domestic liquidity in the economy.

Thus, the repo rate, often referred to as the short-term lending rate, is the interest charged by the central bank on borrowings by commercial banks. A hike in the rates makes cost of borrowing costlier for the commercial banks.

Reverse Repo Rate:

“Reverse Repo” rate is just what the name suggests. It’s the reverse of the repo.

A reverse repurchase agreement or a ‘reverse repo’ is something like a switch between the buyer and the seller in a repurchase agreement. More specifically it’s a switch in the perspective.

For example in the case of reverse repo, the RBI would be the one,who will be selling the security to the commercial bank and telling it….if you give me Rs. 100 for 3 months today, I’ll pay you Rs. 3 as interest on it after 3 months and you give me back this security.

So it is actually a ‘repo’ from RBI’s perspective but a ‘reverse’ repo from the commercial bank’s perspective.

I hope you got the difference. The interest rate that RBI promises the commercial bank for placing its money with RBI is the reverse repo rate.

The following table summarizes the terminology:

Repo Reverse repo
Participant Borrower Lender
Seller Buyer
Cash receiver Cash provider

Near leg Sells securities Buys securities
Far leg Buys securities Sells securities

Impact of these on Us:

When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can say that in case, RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate:)

Thus, a hike in these rates makes cost of borrowing costlier for the commercial banks.

An increase in the reverse repo rate means that the RBI will borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep their money with the RBI.

A hike in this rate makes it more lucrative for banks to park funds with the RBI(which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk).

Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy.

Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while Repo rate signifies the rate at which liquidity is injected.

The Central bank uses these rates to control inflation.

Banks earn profit by borrowing at a lower rate of interest from the central bank, and lending the same amount at a higher rate to the customers.

If the repo rate or the bank rate is increased, bank has to pay more interest to the central bank. So in order to make profit, banks in turn increase their interest rate at which they take deposit from the customer and lend money to the customer. So the demand for loan decreases, and people start putting more and more money in bank accounts to earn higher rate of interest. This helps in controlling inflation.

An increase in Reverse repo rate causes the banks to transfer more funds to the central bank, because banks earn attractive interest rates and also their money is in safe hands. This results in the money being drawn out of the banking system, thus banks are left with lesser funds.

Thus, by lowering repo rate, central bank injects liquidity in the banking system and by increasing reverse repo rate it absorbs liquidity from the banking system.

Thus, we 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.

Increase in CRR rate means that banks will have less power to give loans (see our example above), which again controls the amount of money floating in the market; thereby controlling inflation. It also makes banks safer to keep money because banks will have a higher liquidity to meet the demand of customers. As we learnt from the recession, giving loans expose banks to great risks. So if banks have lesser funds to give as loan, they become relatively safer.

Inflation...

Suppose you are purchasing some goods worth Rs.100/- today. We all know that in a year’s time, you would require more than Rs.100/- to purchase the same goods as you have done today. This is due to the “Rise in Prices”. This phenomenon is observed constantly in almost all the economies, though the degree of increase would depend upon so many factors and hence it differs from time to time and country to country.

This “increase” in prices is due to the fact that at any given time, more money chases less goods and services. This means that there exists a gap between “Supply” and “Demand” of goods and services and the degree of price rise directly depends upon the extent of gap. The more the gap the higher the price rise and vice-versa. This general increase in prices of goods or services with the passage of time is called “Inflation”.

Inflation in India as a Developing Country:

All Developing Countries experience a fair to heavy dose of Inflation depending upon the Current Growth Rate of the Economy. Usually, when the economic activity is at its peak in the growth phase in any country, the rate of Inflation tends to be high, as money in circulation increases appreciably and growth in terms of economic activity requires a little time to catch up with.

India, as a developing country is no exception to this phenomenon of “Inflation”. At present, it is indicated that the rate of Inflation as per “Wholesale Prices Index (WPI) ” is around 9%.

However, in all Developed Economies, the rate of Inflation is measured in terms of “Consumer Prices Index”, which is the correct measure, as consumers do not buy at wholesale prices and that in a country like India, there are any number of intermediaries between wholesale trade and retail trade; usually, the average consumer gets his goods from the retail trade and not the wholesale trade.

What do you mean by “Rate of Inflation of 5%”?

This means on a comparative basis, the difference between prices of a basket of Commodities last year and this year works out to 5%. Hence, in case there is a reduction in the rate of Inflation, it does not mean that the prices have come down in an absolute sense. It only means that the rate of increase in price rise of a basket of selected commodities has come down.

What is the difference between inflation in a Developing Country and a Developed Economy?

Inflation in a Developing Country appears due to the gap between “Supply” and “Demand” of goods and services, whereas, in a Developed Country, this is not the case.

Developed Countries experience, what is known as “Cost Pushed” Inflation. This essentially occurs because of “high levels of income”, which pushes up the “Cost of Production”, resulting in Inflation. This does not necessarily indicate that there is a gap between “demand” and “supply”.

Inflation and Interest Rates:

In any Economy, there is a 4-tier Structure for Rates of Interest as under:

Tier No. I – Rate of Inflation;

Tier No. II – Rate of Interest on Deposits, i.e., Rate of Inflation + Certain % loading depending upon the degree of compensation expected by the Depositors;

Tier No. III – Rate of Interest on Loans, i.e. Rate of Interest on Deposits + Certain % loading depending on the risk perceived in the lending activity by the lender which could be borrower specific and the profit margin of the lender and

Tier No. IV – Rate of return expected by a promoter from Investment in a project = Rate of Interest on Loans + Certain % loading as a reward for the risk incurred by the promoters in the project.

What is “Time Value of Money”?

That with the passage of time, the value of “Present Money” reduces due to “Inflation”is clear to us and this phenomenon is referred to in finance as “Time Value of Money”.

Interest is in fact primarily a Compensation for the loss in value of money due to passage of time. Hence we should familiarize ourselves with terms associated with “Time Value of Money”such as “Compounding and Discounting”.

Compounding: It is a process by which given a specific present value, at a fixed rate of interest and depending upon the frequency of compounding, the future compounded value can be determined for a specific period.

All of us know this formula to be

F.V. = P.V. (1+ r /100) rose to “n” times, “n” representing the period in number of years.

This presupposes that the periodicity of compounding is yearly.

In case the periodicity of compounding is half-yearly, then the formula would change as follows: F.V. = P.V. (1+ r /200) raised to “2n” times. Similarly, the formula could be amended for quarterly compounding or monthly compounding.

Discounted value: This is converse to the process of “Compounding”. Just as we know the present value for compounding, we should know the future value for discounting.

This value, when discounted at a given rate of discount, which is usually the rate of return expectation, by a promoter or an investor gives us the present value.

This again depends upon the period for which the discounting is done. Just as in the case of compounding, in the case of discounting also, the formula which is given below needs amendment for adjusting for a more frequent periodicity of discounting than 1 year. P.V. = F.V./(1+r/100) raised to the power of “n”, wherein “n” is the number of years.

This discounting is useful for saving a fixed sum at a future date and for evaluating projects, whose cash flows can be determined now for a future date.

Types of Inflation & its Basics

There are two theories in the economics that are generally accepted as the causes of inflation.

• Demand pull inflation – Happens when too much Money chases too few Goods.

This situation mostly exists in a Growing economy (Like India), where there are huge expansions from the Government and Private Sector, leading to increase in employment, which in turn will increase the purchasing power of the consumer.

This leads to an environment, where people have got too much money to buy goods and/or services, but the supply of goods and services are not growing at the same rate, resulting in a supply and demand mismatch. To adjust this, producers will increase the price of goods.

• Cost push inflation – Happens when the aggregate cost of resources goes up, for the companies due to decrease in supply or increase in taxes. This situation primarily exists in Developed Economies such as US or UK.

Companies pass this increase on to consumers in the form of increased prices. For example, Crude oil prices have gone up sharply in past few months on account of decrease in supply. The economy sectors where oil is the part of their cost element, will pass on this increase to customers by increasing prices of their goods and services.

It is not necessary that only one type of inflation exists in an economy at a time. They can co-exist.

For instance, in India right now we have both types of Inflation, Oil and Metal prices have gone up to record highs, giving rise to Cost Push Inflation. At the same time, purchasing power has also increased due to increases in employment, wages, and easy availability of money, creating Demand Pull Inflation. This combined effect has taking inflation to the 13-year high that we are experiencing right now.

Inflation is not always an Evil.

Within limits, Inflation is required for an Economy to grow. It’s very well said that inflation is the sign of a growing economy. Imagine an environment where there is no price increase; in fact prices are falling (this situation is opposite of inflation known as deflation). There will be no increase in wages. Nobody would like to have that environment.

But when inflation is too high it adversely affect the consumer and the economic conditions of the nation as well:

• In a fixed interest rate environment the Creditor will lose money, if he has not properly estimated the inflation and accordingly fixes the interest rate. High inflation can sometime result in negative real interest rates. This can be currently seen in India as the inflation is touching 11.4% and the interest rate on fixed deposit is 9% it is actually giving negative return of 2.4%
• It decreases the savings of the individuals. As the prices increase, the consumer has to shell out more money from his pocket to buy the same products but his income has not increased. Therefore he has to eat up his savings.
• As savings get reduced, automatically investments will reduce, affecting the economy negatively.
• If the inflation in one country is greater than another, the products and services of the former will become less competitive due to the increase in its prices.

To control inflation Central Banks, take Monetary actions and government takes fiscal measures. But individuals should also take some steps to get over it. They should invest their money in the investment avenues which gives better return, should try to minimize unwanted expenses, reduce the consumption of the commodity that has become very expensive, and find out some substitute that will help them in managing their own inflation.

Relation between Inflation and Bank Interest Rates: How does Inflation affect rates?

“Inflation is the overall or specific increase in the cost of goods or services.”

Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole.

Inflation is basically a rate of increase in the price of goods and services which in economics defined as “The overall general upward price movement of goods and services in an economy, usually as measured by the Consumer Price Index (CPI).”

In India, however, it is measured using the wholesale price index (WPI).

The CPI is based on a basket of goods and services with different weights, reflecting the expenditure of a typical consumer. The weighted average of price rises of these goods and services gives the inflation figure.

Inflation simply reduces the worth of our money. For example: the same 1 kg of apples you used to buy at Rs. 100 will cost you Rs. 110 next year, if the inflation remains at 10%.

Inflation is when our Mom or Dad complains about the prices they have to pay nowadays compared to what they paid when they were younger. “I remember when a roll of Poppins only cost 20 paise.” “I used to buy Tur dal at Rs.14/Kg.” “When did milk get so expensive?” My Great Grandfather used to get a salary of Rs. 5 per month!!

Most people look at their present living standards and estimate how much they will need to accumulate to survive. They don’t even take a second look at inflation. India’s Inflationrate is currently above 9%. There are no Fixed Deposits which give such high returns. This means that for every year that your money is in the bank you are actually losing money!! Inflation is Eroding the value of our money lying idle in Savings Accounts in Banks, as it is fetching us only 4% ROI.

The best way to beat inflation when planning for the future is to include it in your calculations. The biggest problem we see with a lot of long-range financial planning, especially retirement planning, is that people forget to factor in the effect of inflation on their investments and savings.

Another quick way to account for the effect of inflation is to subtract the inflation rate from any rate of interest you will be receiving on an investment. So if you are going to assume a 10% inflation rate and the assumed rate of return is 11%, do the projection with only a 1% rate of return. This will give you a more accurate picture of the value (not the amount) of the investment at its maturity!!!.

If inflation is high, interest rates are increased. If repo, ie rates at which banks borrow from RBI, is increased, such borrowing will become costly and banks would thus either borrow less or pass on this increased cost to their borrowers. Again if reverse repo is increased, banks would divert more funds towards RBI and excess liquidity will be absorbed by RBI rather than going at cheaper cost in the economy. In either of the cases, actual lending will be less and demand for goods and services will be less

In the case of CRR, if the rate is increased, it affects in two ways. First, immediate liquidity in the system is absorbed to the extent CRR is increased as more money needs to be placed with the regulator. Second, in the incremental lending, potential capacity of banks to lend is curtailed. This again leads to less lending by banks.

How is inflation calculated in India?

India uses the Wholesale Price Index (WPI) to calculate inflation. Most developed countries use the Consumer Price Index (CPI) to calculate inflation.

What is Wholesale Price Index (WPI)?

Wholesale Price Index (WPI) is the index that is used to measure the change in the average price level of goods traded in the wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. WPI is published on a weekly basis in India.

What is Consumer Price Index (CPI)?

CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation. In India, CPI is published on a monthly basis.