Prelims Syllabus : Polity & Governance- Constitutional Bodies, Regulatory Bodies; Economics- Banking Mains Syllabus : GS-II- Government policies and interventions for development in various sectors and issues arising out of their design and implementation.
- In a bid to augur economic activity amidst slowing consumption demand, the monetary policy committee of Reserve Bank of India on Wednesday unanimously decided to go for its fourth cut this year.
- With a 35 basis point cut (highest this year) the repo rate, at which RBI lends to commercial banks, stood at a 9-year low of 5.4 per cent, since July 2010 when it was 5.25 per cent.
- The previous three cuts this year were 25 basis points each. Alongside a cut in the repo rate, the central bank also lowered its GDP growth projection from 7 per cent in June policy to 6.9 per cent now.
Why the Rate Cut?
- While inflation is a key consideration for a rate cut and it provided RBI the comfort to go for a cut, the decision was also taken to boost aggregate demand especially private investment.
- The monetary policy statement said that “inflation is currently projected to remain within the target over a 12-month ahead horizon”.
- The RBI statement further said that
- Domestic Economic activity continues to be weak,
- With the global slowdown and
- Escalating Trade Tensions posing downside risks.
- It added that while private consumption, the mainstay of aggregate demand, and investment activity remain sluggish.
Why Has Growth Been Revised Downwards GDP?
- This is the second consecutive policy statement where the RBI has lowered its GDP growth projection for 2019-20.
- While in June statement it revised it projection downward from 7.2 per cent (stated in April 2019) to 7 per cent.
- This time it further revised the growth projection further down to 6.9 per cent.
- The RBI said that “various high frequency indicators suggest weakening of both domestic and external demand conditions…business expectations Index of the Reserve Bank’s industrial outlook survey shows muted expansion in demand conditions in Q2, although a decline in input costs augurs well for growth”.
- It said that the monetary policy easing since February 2019 is expected to support economic activity, going forward.
Significance of Monetary Policy:
- It influences the interest rate in the economy — which is the cost of money when you don’t have it, and the reward for parting with it when you have it.
- In any economy, economic activity, which is measured by gross domestic product or GDP, happens by one of four ways.
- One, private individuals households spend money on consumption.
- Two, the government spends on its agenda.
- Three, private sector businesses “invest” in their productive capacity.
- And four, the net exports — which is the difference between what all of them spend on imports as against what they earn from exports.
- At the heart of any spending decision taken by any of these entities lies the question: What is the cost of money?
- Monetary policy essentially answers that question
- In every country, the central bank is mandated to decide the cost of money, which is more commonly known as the “interest rate” in the economy.
- While various factors make it difficult for a central bank to exactly dictate interest rates, as a thumb rule, RBI’s decision on the repo rate sets the markers for the rest of the economy. In other words, the EMI for your car or home is determined by what the RBI decides.
What Is the Repo Rate?
- Repo and Reverse repo are short for Repurchase agreements between the RBI and the commercial banks in the economy.
- In essence, the repo rate is the interest rate that the RBI charges a commercial bank when it borrows money from the RBI.
- As such, if the repo falls, all interest rates in the economy should fall. And that is why common people should be interested in the RBI’s monetary policy.
But the interest rate for consumer loans has not reduced by 110 bps since February. Why?
- In the real world, the “transmission” of an interest rate cut (or increase) is not a hundred per cent.
- And that is why, even though when the RBI cut by 35 bps lay consumers may only receive a much lower reduction in the interest rate on their borrowings.
- This is due to a lot of factors — but primarily, it has to do with the health of the concerned commercial bank.
Issues with Commercial Bank
- Over the past few years, almost all banks, especially the ones in the public sector, have seen their profits plummet because many of their past loans have turned out to be non-performing assets (in other words, they are not getting repaid).
- To cover for these losses, the banks have to use their existing funds, which would have otherwise gone to common consumers for fresh loans.
- Lag in monetary policy
- The reduced repo rate applies only to new borrowings of banks. The banks’ cost of existing funds is higher. Of course, funding costs would eventually come down — but this process would take time.
- This “lag” in monetary policy is a key variable in determining the efficacy of any rate cut by the RBI.
- It could take anywhere between 9 and 18 months for the full effect of an RBI decision to reflect in interest rates across the economy.
Will the rate cut bring Investments?
- Investments depend essentially on the “real” interest rate.
- The real interest rate is the difference between the repo rate and retail inflation.
- When making an investment decision, it is this interest rate that matters.
- As a variable, it allows an investor to compare the attractiveness of different economies.
- Real interest rates in India have been rising, and that is one of the biggest reasons why investments are not happening.
- The RBI’s move would reduce the real interest rate and hopefully attract more investment.
Monetary Policy Committee Composition
- Governor of the Reserve Bank of India – Chairperson, ex officio; (Shri Shaktikanta Das)
- Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy- BP Kanungo (Member, ex officio).
- One officer of the Reserve Bank of India to be nominated by the Central Board – Member, ex officio; (Dr. Michael Debabrata Patra)
- Ravindra H. Dholakia, Professor, Indian Institute of Management, Ahmedabad – Member.
- Professor Pami Dua, Director, Delhi School of Economics – Member
- Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) – Member.