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Will your loan become more expensive?
Prasanna Zore
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January 30, 2007

Come January 31 and the Reserve Bank of India -- also popularly known as the RBI -- will announce its credit policy for the Indian banking sector.

On January 31, RBI governor Yaga Venugopal Reddy will take us through a quarterly review of the Indian economy before announcing key policy rates like the bank rate, repo rate, reverse repo rate, etc.

Already drowning in jargon? Didn't understand a word you read so far?

Let's find out what these technical sounding terms actually mean:

Bank Rate

This is the rate at which any central bank (RBI in India's case) lends money to other banks (for example, State Bank of India, ICICI Bank, etc) or financial institutions (for example, LIC Housing Finance).

The bank rate signals the central bank's long-term outlook on interest rates. If the bank rate moves up, long-term interest rates also tend to move up, and vice-versa.

Banks make a profit by borrowing at a lower rate and lending the same funds at a higher rate of interest. If the RBI hikes the bank rate (this is currently 6 per cent), the interest that a bank pays for borrowing money (banks borrow money either from each other or from the RBI) increases. It, in turn, hikes its own lending rates to ensure it continues to make a profit.

Bankers, economists and stock market experts are most interested in how the RBI deals with this key policy rate. The general feeling among them is that the RBI may keep the bank rate unchanged, while increasing the repo rate and reverse repo rate to control inflation.

How this affects you: If the RBI keeps the bank rate unchanged, you may not really be affected. But if it increases the bank rate, be prepared to pay more for any loan you take from a financial institution.

The bank rate will also give you an idea of the RBI's long term view of the economy. If the bank rate goes up, it means things are going to get more expensive in the long run.

Repo (Repurchase) Rate

Repo rate is the rate at which banks borrow funds from the RBI to meet the gap between the demand they are facing for money (loans) and how much they have on hand to lend.

If the 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. 

How this affects you: If the bank is paying a higher rate of interest to borrow money, you are the one who will bear the cost -- you will pay a higher rate of interest when you borrow money from them. This is how banks ensure that they continue to make a profit.

For example, let's say you need money for some reason and you apply for a loan. The bank may have already exhausted all its available money by lending to other borrowers and does not have enough money to lend to you.

This does not mean it will refuse your loan request.

The bank will go to the RBI and ask for money. The RBI lends this money to the bank at a fixed rate of interest (the repo rate fixed during the credit policy; the credit policy is announced every quarter). This tool helps the RBI increase the amount of money flowing into an economy (that is, it brings more money, as and when needed, into the banking system).

In the credit policy which was announced in October 2006, the RBI increased the repo rate from 7 per cent to 7.25 per cent. It did this in order to control the increasing inflation by controlling the amount of money that entered the economic system. In the last 18 months, inflation has increased from less that 4 per cent to almost 6 per cent.

Reverse Repo Rate

This is the exact opposite of repo rate.

The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate. The RBI uses this tool when it feels there is too much money floating in the banking system; this too leads to inflation.

For example, take a look at the housing industry today -- there is so much of money available in terms of bank loans and increased salaries that the prices for homes, and for land, has sky-rocketed.

If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money 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.

Though RBI can use both repo and reverse repo to control the amount of money in the system, it is the reverse repo that the RBI prefers as a credit management tool. It was only during the October 2006 credit policy that the RBI, after a long gap, increased repo rate to control inflation.

As of today, the reverse repo rate stands at 6 per cent and the repo rate is 7.25 per cent. Any monetary authority lends money at a higher rate and borrows at a lower rate. RBI, too, is a clever money manager. It lends money to banks at 7.25 per cent (repo rate) and borrows money from banks (reverse repo rate) at only 6 per cent, maintaining a neat difference/ profit of 1.25 per cent.

How this affects you: Again, if the RBI increases the reverse repo rate, consider it bad news. It means the banks have less money to lend -- since they will keep quite a bit of it with the RBI. As a result, you will have to pay a higher rate of interest if you are planning to apply for a loan.

If you are lucky, though, and the bank does not want to lose you as a client, it may absorb the increased interest and not pass the cost to you.

Liquidity Adjustment Facility (LAF)

This is the mechanism through which the RBI drains out funds (reverse repo) or injects money (repo rate) into the banking system.

Actually this is the window through which the RBI conducts its repos and reverse repos.

RBI conducts both these operations depending on the demand and supply of funds in the banking system. If RBI thinks that there is more money chasing few goods it drains out the excess by opening the reverse repo window. If the money supply is tight, RBI opens the repo window.

Prime Lending Rate (PLR)

This is the rate at which banks lend money to their prime customers. This rate is often lower than the rate at which banks lend money to their other customers.

Most PLR customers are top blue-chip companies that have excellent credit records (have never defaulted on their interest payments to the banks from which they borrowed money).

If the RBI increases the bank rate on January 31, banks will go ahead and increase their PLRs.

How this affects you: This, in turn, will increase your home loan rates as they are linked to (benchmarked to) PLRs. Home loan rates are always priced below a bank's PLR as they fall under the priority sector category.

Personal loans and vehicle loans, on the other hand, are always priced above a bank's PLR.

Statutory Liquidity Ratio (SLR)

As a statutory obligation under Section 24 (b) of the Banking Regulation Act, 1949, every bank has to keep a fixed minimum portion of their Net Demand (savings account) and Time (fixed deposits) Liabilities (NDTLs) aside at the end of every day.

The SLR can be in the form of cash, gold or bonds issued by the government (a financial instrument for which the government pays a fixed rate of interest to the buyer).

While demand deposits can be withdrawn any time without giving any prior notice, time deposits need a notice period for their withdrawal.

The SLR is always expressed as a percentage of the NDTL. If a bank's NDTL is Rs 100 on January 31 and the SLR fixed by the RBI is at 20%, then that bank has to either keep Rs 20 aside or invest it in gold, bonds or both. This means that only Rs 80 will be available to the bank for its lending operations.

The savings account deposits as well as fixed deposit amount that we deposit in a bank are the bank's liabilities. The SLR as of today stands at 25% and the RBI has the authority to increase it to a maximum of 40%.

Any reduction in the SLR level increases the amount of money available with banks for lending to individuals, companies or other banks. Any hike in the SLR has the opposite effect.

How this affects you: A reduction in SLR, ideally, means you should have to pay a cheaper rate of interest on your loans and vice versa.

Cash Reserve Ratio (CRR)

As per section 42 (1) of the RBI Act, 1934, every commercial bank has to maintain with the RBI (every fortnight) a minimum of 3% of its NDTLs compared to the previous Friday.

For example, if CRR is to be calculated today (assuming that today is that reporting fortnight), then it will be only 3% of the NDTLs on the previous Friday.

Found that confusing? Here's an example that should make it easier.

Assume January 26 is the Friday on which the bank has to make its report.

Bank A, which has a NDTL of Rs 100 on January 19 (the previous Friday), will have to maintain a CRR of Rs 3 with the RBI on January 26 (assuming it has been asked to keep a CRR of 3 per cent).

CRR, as of today, stands at 5.5 per cent. This is over and above the SLR requirement

Gross Domestic Product/ National Income (GDP)

It is the money value of all goods and services produced by a country in one accounting year. April 1 -- March 31 is considered as one accounting year, or a financial year, in India.

A labourer working in an iron mill, a weaver spinning yarn, a farmer harvesting crop or a software engineer writing code all get paid at the end of the month; in some way, they convert their effort into money.

If you read something like the RBI expects India's GDP to grow at 9% for fiscal (accounting) year 2007, it means that if India's GDP in 2006 was Rs 100, this financial year it would be Rs 109.

Many people prefer to write national income instead of GDP.

Inflation

It is the general increase in the level of prices. The inflation rate is measured every week and announced on Friday. Most news publications report them on every Saturday. You can get this rate by Friday afternoon if you watch a business channel or surf online; you'll find it on rediff.com as well.

If someone tells you that prices of sugar, oil, fruits and pulses are increasing, what they actually mean is the inflation rate is increasing.

It is also calculated on a year-on-year (YoY) basis. If inflation on January 26, 2007, is say 5.9% it means that prices in general have increased by 5.9% when you compare it to the prices on January 26, 2006 (YoY).

Credit Policy

An announcement made by the RBI after a review of the Indian economy is termed as credit policy. It announces changes in key credit management tools like the bank rate, repo rate, reverse repo rate, SLR and CRR.

In its credit policy, the RBI makes a statement on the country's economy, expected GDP growth rate in a quarter or a year, the level of inflation that it will be comfortable with, and a host of other things.

As of now the RBI is concerned aboutr inflation, which has breached the 5.5 per cent level it was comfortable with. It is in this backdrop that the bankers, stock market punters and economists believe the RBI will hike key indicative rates like the CRR, reverse repo and the bank rate.

The RBI's decisions will impact banks, the stock markets, economists, various other economic agents and even you and me. It will affect our decision, or how much we have to pay for home loans, two-wheeler loans or personal loans.

Money Market

It is a market that helps banks borrow or lend money for a very short duration. Most of this lending/ borrowing is done for a day or two. It is also called the overnight market.

A bank that needs money to meet its short-term obligations borrows money; a bank having funds in excess of its requirement lends them. It functions like any other normal market where demand and supply dynamics decide upon the lending and borrowing rates.



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