Friday, January 29, 2010

WHAT IS CRR,REPO RATE,SLR & HOW IT EFFECTS ECONOMY,INFLATION BANK RATE.


on Friday, January 29, 2010

Reserve Bank Of India has reviewed the monetary policy and to squeeze money from the system CRR(cash reserve ratio has been increased to 5.75 % from 5 %)Full policy can be downloaded from here
Download third quarter review by RBI on monetary Policy

Dear Friends,

In last month or so every body have read the words "CRR" "repo rate" & SLR in News paper and wanted to know about it and interested in its effect on various things like Inflation,bank Interest rate and stock price of Bank and other Interest rate sensitive stocks .so we have divided this story in three parts.
(A) Meaning of terms
(B) Impact on Inflation & interest rates
(C) other measure which can be taken

(A) Meaning of terms

  • CRR(Cash Reserve Ratio):Cash reserve Ratio (CRR) is the amount of Cash(liquid cash like gold) that the banks have to keep with RBI. This Ratio is basically to secure solvency of the bank and to drain out the excessive money from the banks. If RBI decides to increase the percent of this, the available amount with the banks comes down and if RBI reduce the CRR then available amount with Banks increased and they are able to lend more.Present rate is (5.75% today 29.01.10) announced
  • Repo Rate:Repo rate is the rate at which our banks borrow rupees from RBI. This facility is for short term measure and to fill gaps between demand and supply of money in a bank .when a bank is short of funds they they borrow from bank at repo rate and if bank has a surplus fund then the deposit the funds with RBI and earn at Reverse repo rate .present rate is 4.75 as on 29.01.2010)
  • Reverse Repo rate is the rate which is paid by RBI to banks on Deposit of funds with RBI.A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.To borrow from RBi bank have to submit liquid bonds /Govt Bonds as collateral security ,so this facility is a short term gap filling facility and bank does not use this facility to Lend more to their customers.       present rate is 3.25 as on 29.01.2010)      
  • SLR((Statutory Liquidity Ratio) is the amount a commercial bank needs to maintain in the form of cash, or gold or govt. approved securities (Bonds) before providing credit to its customers. SLR rate is determined and maintained by the RBI (Reserve Bank of India) in order to control the expansion of bank credit.Generally this mandatory ration is complied by investing in Govt bonds.present rate of SLR is 25 %.(as on 29.01.2010)But Banks average is 27.5 % ,the reason behind it is that in deficit Budgeting ,Govt landing is more so they borrow money from banks by selling their bonds to banks.so banks have invested more than required percentage and use these excess bonds as collateral security ( over and above SLR )to avail short term Funds from the RBI at Repo rate.

Impact on Inflation and Interest rates:

As we all have read the famous line "if all thing remain the same ......".so In all my below paragraphs please note that there are many assumption in fixing the relation between this ratio and interest rates .

SLR and Cash reserve ratio is maintained for bank solvency and Higher ratio of SLR and CRR makes bank relatively safe as higher ratio means they have more of their funds deposited in liquid securities and can fulfill the demand on redemption of deposit from the Bank.lets take an example :suppose a Bank has taken a deposit of 100 from public and CRR is 9 and SLR is 25 then available funds to lend from deposits with the bank will be 100-9-25=66 so their is direct relation between CRR ,SLR and Funds available with bank to lend to public out of deposit received from public .


Impact on Interest rates of this ratios:

Now take point what will be the impact on Interest rates of this ratios:Interest rate are fixed on the Demand supply situation of the amount available with person who want to lend and and person who want to borrow and interest rate is fixed on demand supply of the funds if demand is more and supply is less then interest rate rises up and if demand is less and supply is excessive then interest rate comes down .this relation is based on many assumption as said above.

So RBI is controlling the supply side of the Funds and by changes in CRR and SLR, Bank control the supply side of the money.so when RBI increase these ratio then available funds with the banks will go down and as demand remain the same then people will have to pay more as interest and interest rate will go up.On the reverse if RBI reduce these rates ,then amount available with bank for lending will be increased and they have to reduce rates to lend more.In these situation bank also reduce the rate of short term deposit from public as they have surplus money already to lend.so these rates have double impact the first direct effect is ,bank reduce rate of lending so more money is available with people and second is interest on Deposit will be reduced so more money will be available with the people.
But other side of interest rate i.e demand/off take of loan is also important to set the interest rate .This may be some time region wise and seasonal or other factor also effect the decision of Interest rate .
Impact on inflation
As from the above para we have understood that how these ratio reduce or increase the money supply in the system and we know if more person is demanding few goods then price of goods tends to increase and its called inflation so when RBI reduce these ratios then money supply in market increases and inflation is rises further but in present case this is not the correct and right relation.The Increase in CRR will squeeze 36000 crore from market ,so less money will chase few things means less demand so it will reduce Inflation.

At the time of depression  the reduction of these ratio is to maintain liquidity without disturbing inflation much.while marked is falling and each and every commodity rate going downwards.In these situation after increasing of money supply inflation rate does not goes up as the demand is slow and reduction in commodity prices will nullify the impact of increase in money supply and have less inflationary effects.

But some times in few cases Inflation is due to supply side ,like in case of pulses and sugar the demand is some what the same but production has been reduced and rate has been doubled .In these types of cases Ever Increase in CRR will not have much impact as the problem is from supply side .
Impact of crises on exchange rate:
please note that this explanation is based on many assumptions,

Dollar rate is fixed by demand and supply position of dollar so if there is less supply and more demand of dollar then dollar-rupee exchange rate will go up means dollar value will increase.In present senerio dollar has risen up not the rupee has gone down means the issue is related to more to dollar and less to rupee.more over dollar exchange rates has risen up with all major currencies of the world so as ruppe. 


Dollar($) v/s rupee

Dollar Main Inflow:(supply)
  1. through export
  2. through FII investment in share and Dept market
  3. repatriation fund sent back to India by NRI
  4. Capital receipt Loan.
As the Financial position of FII in their country is not good so they are not investing or waiting and in their own states they need funds or the rates of stock s in their home countries are also attractive so inflow to India has been reduced ,and net balance has gone negative as they are investing less than selling of their investments to save their parent companies in the home countries .

Due to financial crunch demand in USA has reduced so less dollar inflow against Export.

Repatriation by NRI has increased as exchange rate is favorable and now they can send more rupee to their relative with same dollar outflow so they are en cashing it.But their capacity to send more dollar has also been affected due to less income in USA.

Capital receipt has also reduced as the financial company are not willing to lend funds.

Dollar main Out flow(demand)
  1. paid for Import
  2. withdrawal of funds by FII
  3. Capital loan repayment
effects of point 2 has increase the demand of dollar

so from the above dollar demand /supply situation the exchange rates has been increased so fast.

Measure which may be taken in this Crises:(this is based on measures taken by other countries )
  1. Share market:Govt should create a Fund which may be called as Market stabilization fund ,which should me managed by professional agency and should buy good reputed stock from the Market when share are available at throw away prices and sell them when they seems to be overvalued.and the purpose of the fund should be stabilization of the market and welfare of the Investor and not to earn a profit from the market and buying and selling should be on the basis of Long term period.By doing this sentiment will improve ,volatility will be reduced and selling from large FII can be absorbed and in my point of view there is no chance of loss in these venture.To start with 5000-10000 cr fund is enough.Russian govt has adopted this system.
  2. Buying of stocks of private sector Banks:if govt By symbolically purchase shares of some major private banks then it will improve the sentiment and increase the confidence of public in private sector bank .This measures Indicate that banks are sound and govt is also investing in them .More over money received from selling of shares also improve the liquidity position of the banks
  3. To control prices of Sugar,pluses and other eatable ,Govt must have strict policy against all stockist and speculator and should import material from outside as one time relief and should prepare a suitable plan to increase supplies of such things buy giving incentives to farmers and proper rate of their produce and should reduce middlemen out of the system .
  4. More you can add..............

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  1. Appreciable effort by your team for awareness in millions of general public like me.I thank you all from the bottom of my heart.

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  2. You have the best way to narrate key terms like SLR,CRR,REPO and REVERSE REPO RATE.This is very useful information for a general user like me. Thank a lot..
    Rahul Arya

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  3. IT'S AN EXCELENT WAY U HAVEN EXPLAINED THINGS, AND I HAVE A DOUBT WITH THE THIRD POINT U ROUSED WITH, THAT IS, WHEN MIDDLEMEN LOSSES THEIR JOB, INCOME AND CONSUMPTION OF PER PERSON GOES DOWN, SO IT AFFECTS GDP OF THE ECONOMY.
    AND WITH FIRST POINT, HOW CAN WE CREATE THAT HUGE AMOUNT FUNDS TO INVEST IN SECURITIES,AS WE ALREADY IN LAGGING FUNDS FOR EVEN THE SHORT TERM NEEDS, OUR GOVERNMENT BORROWING MONEY FROM OTHER COUNTRIES FOR JUST RUNNING THE GOVENRMENT AND SHORT TERM NEEDS, THEN WHERE DOP I CREATE FUNDS FOR INVESTING IN SECURITIES ALONE, THAT TOOO FOR A LONG PERIOD.
    AND REAGRDING SECOND POINT, AS THE QUERY RAISED SAME IN THE FIRST POINT,WHERE DO I CREATE MONEY FOR SUCH INVESTMENTS.

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  4. good .................a much helpful...........

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  5. Great work. It is very useful.

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  6. Appreciable, you kept it simple & straight.

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  7. Splendid! Precise. Hearty Thanks to author..

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  8. lovely explanation..

    ReplyDelete