In today’s blog we discuss ‘Can the RBI Decide Which Car I Buy?”. In the last few interviews, we have discussed the genesis of economics and how it has evolved over the years. We also spoke about how countries trade with each other. It is however, important to mention that behind all economics lies finance. Which basically means managing the currency and purchasing power of the country and its people.
In this spirit, this blog post would help understand the role which our Central Banks, be it the Federal Reserve (Fed) in the US or the Reserve Bank of India (RBI) in India, plays in our daily lives. To understand this better, we would take the example of the Reserve Bank of India, which as the name suggests, is the Indian central bank.
Garima Dhir: Please tell us what is the Reserve Bank of India?
Akhilesh Verma: Reserve Bank of India is the central bank of India. Most countries in the world have a central bank. Most famously, the central bank of the United States of America is called the Federal Reserve System. Similarly, the central bank of Japan is called ‘Bank of Japan’, that of Sweden is called Sveriges Riksbank (which is, by the way, the oldest central bank in the world), and so on. Think of this central bank as the piggy bank of the country. But this piggy bank is more sophisticated than our regular ones at home. This one not only provides financial services but also decides how much money can be extracted from the piggy bank! In simple words, it acts as the gatekeeper of the financial sector that comprises of banks in which your parents may have opened a fixed deposit, or you have a savings account or the post office where your granny deposits her money.
Garima Dhir: As a consumer, I have no access to this piggy bank, then why is it deciding which car I get to buy?
Akhilesh Verma: So, this piggy bank – which we can call RBI from now on – will not directly write to you, telling you about your car specification, its mileage, variants, etc. and advice you on which one goes best for your budget, but its policies may have an indirect impact on your budget through loan rates that the bank can influence, level of inflation in the country etc. On similar lines, RBI policies can affect rates on bank deposits, credit cards, other financial products such as bonds, etc. which you may use for buying your car.
Garima Dhir: So what you are saying is that while RBI does not directly influence my preferences but it can impact my budget?
Akhilesh Verma: You are right, let me break this down for you. When you deposit money in the savings account or open a fixed deposit, you get an interest over it, which is like an additional income for you and the good part is that for this additional income, you don’t have to do any additional hard work. Similarly, when you take a loan, you pay interest to the bank to borrow money today that you will pay off later. RBI can impact both these components as it plays an important role in deciding the interest rate at which you would get that additional income from your savings and the interest rate at which you can take a loan. And the way RBI does that is that it has some tricks in the bag. So, what are these tricks? These are essentially policy rates, which are of two types:
- Repo Rate – this is the interest that Indian banks pay the RBI when they borrow money from it. Think of it as interest that you and I pay then we take a bank loan. Now you would be thinking why these big commercial banks need to borrow money? Well, even they have further commitments for which they might be falling short!
- The next one is Reverse Repo Rate – this is the interest rate that commercial banks earn when they park money with the RBI. Think of this as the interest you earn on your Savings account or your fixed deposit. I know what you are thinking, do Indian banks really need this “additional income”. I guess no one minds more money!
When RBI adjusts these rates, it affects the citizens in different ways. Apart from these there are various other tools like the Cash Reserve Ratio and the Standing Facility Rate, which the RBI can use to influence the market interest rates.
Garima Dhir: Can you explain this with an example?
Akhilesh Verma: Ok, so let me give you an example of how this works. RBI recently, on 4th May, increased the repo rate by 40 basis points, bringing it to 4.4%. This was after an unscheduled/ off-cycle meeting of the Monetary Policy Committee (MPC) – which decides these key rates for the RBI.
With a rise in repo rate, borrowing money becomes costlier for the commercial banks. In turn, the commercial banks would pass on this additional expense to its lenders, that is, you and me.
Typically, your budget would have 2 parts – the money you have and the money you borrow. Now if it becomes costlier for banks to access money, it would increase the interest rate on your loan. So it becomes more expensive for you to take the loan and you might borrow a lesser amount and thus end up spending less. If earlier you were going to buy a Honda, you might now decide to cut your budget and buy a Maruti.
The reverse would happen if the RBI reduces the repo rate. This can induce the bank to cheapen car loans and help you to get your dream car at a very reasonable rate. So you see, this is why RBI is called “Banker of Banks”.
Garima Dhir: This is quite interesting! From what I understand, the chain of events is that RBI has lent money to commercial banks at a higher rate, and so the commercial bank has lent us money at a higher rate. This was about the Repo Rate, what happens when the Reverse Repo Rate fluctuates?
Akhilesh Verma: When the reverse repo rate increases, the commercial bank will get to earn more on the deposits it would make with RBI. To make most of this situation, banks would want to keep more money with the RBI – additional income at no additional work! As a result, fewer funds would be available for the commercial banks to loan out. If the demand for loans remains the same, the commercial bank would loan out at a higher rate. Having a similar impact as increase in Repo Rate.
Garima Dhir: What happens if I already have a deal with the bank and I have a pre-decided interest rate?
Akhilesh Verma: Well then, you are smart! Change in repo rate affects loans differently, depending upon whether the loan is taken on fixed or floating interest rate. Floating interest rate-based loans are market-linked and interest payment fluctuates when RBI changes the repo rate. However, fixed interest rate-based loans are not market linked and changes in repo or reverse repo rates do not necessarily impact them.
Garima Dhir: So if we were to summarize the functions of the RBI, we could say that it regulates the financial sector and the amount of money that is in the economy?
Akhilesh Verma: Correct. More formally, the central bank provides banking and financial services to its country & government and the commercial banking system in addition to implementing the monetary policy and issuing the currency. Coming to the specific role of RBI, it also does the following –
- When the economy is in trouble, it suggests policies to help the government, that’s why it is called the banker of banks or lender of last resort
- For a relatively more direct impact – RBI prints fresh Rupees or destroys currency and coins not fit for use.
- Apart from the Indian currency, you would also find dollars, Euro etc, in this piggy bank. In other words, it functions as a custodian of foreign exchange reserves in the country (dollars, foreign currency, gold, etc.).