If you want to understand how RBI uses its Monetary Policy apparatus and how rate cuts really work, read this post here – Role of RBI in Indian Economy
What happens when RBI cuts the Repo Rate?
A repo rate cut allows commercial banks to borrow money from the RBI at a cheaper rate.
For example, when RBI cuts the repo rate (i.e. the rate at which RBI is willing to lend to the commercial banks), it results in loans becoming cheaper as commercial banks pass on the benefit of that rate cut to their customers. This increases the demand for credit/ loans – the raw material with which banks work.
Keep in mind: commercial banks are not under any obligation to change their lending rates in accordance with changes to the repo rate, made by the RBI. They may increase or decrease their rates as they want, which is why RBI is constantly urging commercial banks to ‘pass on the full benefit of rate cuts to customers’. However, practically if one bank cuts rates, all others follow suit in order to stay competitive.
Does Repo Rate Cut Really Help?
Borrowing costs for companies in India could be as high as 18% for businesses. Personal loans, car loans and home loans are all available anywhere in the range of 9.70% – 14.50%, depending upon duration and the type of loan. Each time banks cut interest rates in line with RBIs 0.25-0.50% cut, how attractive do things get?
BUSINESS LOAN @ 18%
Sana Securities takes a business loan of Rs. 20 Cr. from XYZ Bank @ 18% for 10 years.
RBI’s cuts interest rates by 0.50%.
JP Morgan takes a business loan of Rs. 20 Cr. from XYZ Bank @ 17.50% for 10 years.
|Sana Securities||JP Morgan
On monthly basis, JP Morgan will enjoy 4.16 % saving over Sana Securities. Isn’t it funny how a 0.50% rate cut by RBI results in over 4% monthly saving for businesses. Keep in mind that based on the profit margins with which businesses operate, this could be pretty much a make or break event!
||105 Cr||10.5 Cr||87.2 lac|
||10.0 Cr||83.6 lac|
HOME LOAN @ 9.90%
Amit takes a home loan of Rs. 2 Cr. from XYZ Bank @ 9.90 % for 10 years.
RBI’s cuts interest rates by 0.50%.
Manoj takes a home loan of Rs. 2 Cr. from XYZ Bank @ 9.40% for 10 years.
On monthly basis, Manoj will enjoy 4.46 % saving.
I am yet to come across any serious study on how much additional home loan, auto loan or business loan off-take happens, when rates fall from let’s say 12% to 11.75%.
Of course RBIs policy action makes a huge difference for the business environment but such actions take a long time to show their impact.
Why Things Differ With FED’s Rate Cut?
Compare RBI’s rate cuts with FED’s policy action in the United States where borrowing costs are as low as 2%. When FED hikes or reduces the rate by 0.25%, it equates to ~12% difference in the overall borrowing costs.
Further, the impact of an RBI rate cut diminishes more when you think about the fact that in India, businesses even beyond the small and medium ones have large appetite for unaccounted money which is virtually nonexistent in the United States. Think about the number of times wedding party discussions scale between 1.75% to 2.5% monthly interest from the unorganized market.
It’s Not All for Long Term
That said, based on RBIs action (even potential action), many traders aggressively buy and sell all sorts of things based on what charts tell them. They create dark clouds over heads and shoulders. There is almost a market which thrives on predicting Raghuram Rajan’s behaviour on anything that will fit the bill ranging from what he said a month ago to how he looked as he walked into a meeting. Money changes accounts as these traders get to work on the – rate cut or no rate cut day. It all looks super by the end of the trading day. In terms of money, it just moves from one trader to the other based on superiority of predictive skills.
Of course it could take many months and years for the real benefit of cheaper loans to flow into the system. This is because in an ideal world companies will take loans to set-up plants and factories which will produce goods in future, which will eventually improve earnings.
However, the irony of it all is that at least in the stock markets, the only people who do anything of consequence based on RBI’s rate cut action are traders who do not care much about what will happen over a longer term.
Why You should track FED’s Rate Action
If the FED hikes interest rates this year, not only will that increase borrowing costs for corporates (as discussed above) but it will also result in a lot of Foreign Institutional Investors (FII) money flowing out of the Indian stock markets, and from many other stock markets.
Why this happens is not as simple as some make it sound, in that, “now FIIs have better (and safer) place to invest their funds so it is no longer an attractive incentive to look for returns in other countries.”
The bigger reason why this happens is similar to what I had discussed above. FIIs leverage and trade on margins. An increase of even a quarter percent would be a big hit for them given that they borrow at about 2%. So if the borrowing cost rises to 2.5 % that is an increase of 25% in their borrowing costs.
Parting thought: just for the sake of comparison, imagine trading stocks with loaned money in India – You will have to beat 12% p.a. just to break even!
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