RBI Hikes Repo Rate, CRR: What Brought It On? How Will It Impact the Economy?

While the repo rate was increased to 4.40 percent, the CRR was hiked by 50 basis points to reach 4.50 percent.

RBI Governor Shaktikanta Das.

(Photo: The Quint/Aroop Mishra)

Reserve Bank of India (RBI) Governor Shaktikanta Das on Wednesday, 4 May, announced an increase in the policy repo rate by 40 basis points to 4.40 percent, as per the decision taken by Monetary Policy Committee (MPC).

Further, the Cash Reserve Ratio (CRR) was also raised by 50 basis points to 4.50 percent, effective from 21 May.

"Consequently, the standing deposit facility (SDF) rate stands adjusted to 4.15 percent and the marginal standing facility (MSF) rate and the Bank Rate to 4.65 percent," the RBI had said in a statement.

The hike in the benchmark interest rate comes after an unscheduled meeting with a view to contain inflation in the country, which is close to 7 percent currently.

A lot is being said about the RBI's surprise move. What are the dynamics behind the move, and what impact will the decision have on the economy?

What is Repo Rate?

The repo rate is the rate at which the RBI lends money to commercial banks in the country, if they face a lack of funds. The central bank gives short-term loans to commercial banks against government bonds or treasury bills.

The repo rate is basically used by the central bank to have a handle on inflation by regulating liquidity. When a country faces high inflation, a rise in the repo rate acts as a brake on the borrowing capacity of commercial banks, as the banks would have to pay more interest on loans.

This eventually leads to a reduction in money supply in the economy, thus reducing the rate of inflation.

On the other hand, the repo rate is decreased when the central bank aims to bring more money into the economy to boost growth.

Any change in the repo rate is bound to have an impact on public borrowings, like Equated Monthly Instalments (EMIs), home loans and corporate loans.

The increase in the repo rate comes after it had been reduced to 4 percent by May 2020. That was the last time the RBI had slashed the repo rate with the objective of increasing economic turnovers amid the COVID-19 pandemic, which had stalled all sectors of financial growth.

The reverse repo rate (RRR), on the other hand, is the rate at which the RBI pays commercial banks to keep their cash in the central bank. It is used by the RBI to regulate cash flow in the economy.

When the central bank requires money, it borrows from commercial banks and pays them interest according to the RRR.

When the inflation rate is high, the RBI hikes the RRR to incentivise commercial banks to deposit money in the central bank. This in turn leads to the withdrawal of surplus funds in the market, thus reducing the money available for borrowing by consumers.

What is the Cash Reserve Ratio? 

The Cash Reserve Ratio (CRR) refers to the share of a commercial bank's deposits that it needs to keep at the RBI in the form of liquid cash.

The extent of the CRR that commercial banks must keep at the central bank is decided upon by the latter. Banks are not permitted to use the CRR for providing loans; nor can CRR deposits be used to earn interest.

The CRR fixed by the RBI helps to ensure that banks always have adequate cash to disburse when there is a requirement by depositors. The goal of the CRR, once again, is to regulate inflation in the country.

When the CRR is hiked, as announced by the RBI on Wednesday, the cash held in commercial banks is reduced. This leads to a reduction in their lending capacity, which reduces borrowings and helps to curb inflation.

Why Has the Repo Rate Been Increased Now?

The most obvious reason for the repo rate being increased is to combat inflation in the country, which had reached 7 percent in March, and is expected to increase even further when estimates for April are revealed.

The ideal inflation target, according to the RBI, should be between 2-6 percent.

The inflation is being pushed forward by a number of factors, prominently the rise in food and fuel prices.

Geopolitical tensions, triggered by the Russia-Ukraine war, have also been termed a significant reason by the RBI for its decision on Wednesday, apart from the aim to stabilise the economy, which is still recovering from the third COVID-19 wave.

"Since the MPC’s meeting in April 2022, disruptions, shortages and escalating prices induced by the geopolitical tensions and sanctions have persisted and downside risks have increased," the central bank said in a statement on Wednesday.

The interest rate hike is aimed at strengthening and consolidating medium-term economic growth prospects, the RBI governor said, pointing out that geopolitical tensions were pushing inflation.

How Will the Hike in Repo Rate, CRR Impact the Economy?

The principal impact of the hike in the repo rate would be on EMIs on home, vehicular and corporate loans, which could see a hike in interest rates.

Borrowing had already become more expensive, as banks like the State Bank of India (SBI), Bank of Baroda, Yes Bank and Axis Bank had hiked the Marginal Cost of Funds-based Lending Rate (MCLR) recently.

On the other hand, the RBI's decision may benefit depositors who put their money in fixed deposits (FDs) and savings accounts, as banks may offer better interest rates on FDs.

The rise in the CRR, on the other hand, will tend to withdraw liquidity of around Rs 87,000 crore from the banking system, leading to a reduction in lending capacity of banks. As a result, the interest margins of banks may start to move even higher.

'Sudden, Out of Turn': Industry Experts React to RBI's Move

Industry leaders have taken a jolt at the unscheduled hike and said that they were expecting the RBI to make an announcement in June.

Dhiraj Relli, MD and CEO of HDFC Securities, told The Indian Express that the 40 basis points hike in repo rate is much higher than the mark expectation of 25 basis points in the June meeting.

"RBI is no longer behind the curve to react to rising inflation numbers. In terms of timing, it took everyone by surprise and the hike of 40 bps is higher than the market expectation of 25 bps in the June meet," he said, predicting that the Nifty could remain under pressure for some time.

Meanwhile, Sujan Hajra, Chief Economist and Executive Director at Anand Rathi Store & Stock Brokers, said that the RBI’s off-cycle hike in the repo rate is driven by three factors: inflation concerns, the perception that the RBI is falling behind the curve and the US Fed’s anticipated 50 bps rate hike.

"We expect immediate increase in money market rate, some transmission in the long-term bond market and also credit market (both lending and deposit rates). The impact on the equity market is likely to be negative in the short-term," Hajra added.

Pradeep Multani, the president of PHD Chamber of Commerce and Industry, said that the revised repo rate will hurt the sentiments of businesses and consumers.

He pointed out that the economy was still recovering from the COVID-19 pandemic, and that geopolitical tensions would have a "contagious impact" on trade and finance.

Calling the RBI’s hike a "surprise package", UR Bhat, co-founder and director of Alphaniti Fintech, said that markets will eventually come to terms with the central bank’s decision, Business Standard reported.

However, he added that that "on the whole, it was a surprise package, which was done out of turn."

Bhat also said that he does not foresee a downside in the S&P BSE Sensex and expected the Nifty 50 to plunge to around 16,000 points before recovering.

(With inputs from The Indian Express and Business Standard.)