With the inflation levels not relenting at all, the expectation on rate cut seems increasingly a pipedream. But the good news is that the indication of such cuts to be announced by RBI in its October 2012 credit policy seems to be positive. New home loan seekers and existing borrowers can expect some cheer in the coming weeks.

In its September 17 announcement, the RBI cut the CRR by 0.25 per cent or 25 basis points which infused Rs.17,000 crore into the banking system, which was welcomed as a positive step by the finance and banking fraternity. This article explores the effect of RBI’s policy on interest rates and how it affects the economy, banking system and the borrowers.

Savings encouraged

The primary function of the financial system of a country is to mobilise capital where savings is encouraged through short-term and long-term deposits. The cheapest and most viable form of mobilising capital is through fixed deposits. Here there is a close relationship with CRR and interest rates. CRR is Cash Reserve Ratio, which actually is a portion of the total deposit reserves that a bank holds which needs to be kept with the RBI. To understand this from an illustration, if a bank is holding Rs.100 crore as deposit reserves with itself and the RBI stipulated CRR rate is 4.50 per cent, then Rs.4.50 crore should be transferred to the RBI’s account in cash.

In effect the bank will be able to utilise only Rs.95.50 crore for its lending activities. Moreover, this portion that is to be deposited with RBI does not earn any interest, which is idle money for a bank.

Higher the CRR ratio, lesser will be the available funds with the banks, hence the banks will start increasing the offering rates on the fixed deposits to mobilise capital, which in turn will have an effect on the lending rates.

Why the increase?

Then why does RBI increase the CRR rates? With excess money at its disposal, due to lower CRR rates, banks will start running larger loan books which could increase the default rates (NPA). To curb such instincts, the RBI puts a leash by increasing the CRR. This will suck excess liquidity with the banks and make them undergo a need for liquidity.

Further, when the interest rates are softer, people with surplus money will not be inclined to invest their money in not-so-profitable instruments and will start venturing into risky opportunities, that is when we see a steep raise in prices in the share market, commodity costs, and real estate values.

Also the loan taking ability will rise due to increased disposable income and people will start committing themselves to higher EMIs with increased loan commitments. Both the above scenarios lead to price rise which in fact leads to higher inflation. This is the time when the government intervenes through RBI’s policy whereby the deposit rates is increased, thereby making it an attractive investing proposition for investors. While the raise in deposit rates will automatically increase the lending rates, the borrowing activity will in turn reduce. In an increased borrowing rate scenario people prefer to keep their money in safe zones such as bank deposits and refrain from taking loans. But the problem for the economy is much larger than anyone can imagine in such scenarios. With people hoarding their cash by way of deposits with banks and RBI increasing CRR rates, the economy’s growth starts crippling.

People will save but will not invest or take a loan which affects various markets and also sectors such as automobile, real estate, and banking. Consequently financial institutions will bear the brunt of a slow growth.