Monthly Archives: July 2008

Liquidity Adjustment Facility (LAF)

This is the mechanism through which the RBI drains out funds (reverse repo) or injects money (repo rate) into the banking system.

Actually this is the window through which the RBI conducts its repos and reverse repos.

RBI conducts both these operations depending on the demand and supply of funds in the banking system. If RBI thinks that there is more money chasing few goods it drains out the excess by opening the reverse repo window. If the money supply is tight, RBI opens the repo window.

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Reverse Repo Rate

This is the exact opposite of repo rate.

The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate. The RBI uses this tool when it feels there is too much money floating in the banking system; this too leads to inflation.

For example, take a look at the housing industry today — there is so much of money available in terms of bank loans and increased salaries that the prices for homes, and for land, has sky-rocketed.

If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk)

Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy.

Though RBI can use both repo and reverse repo to control the amount of money in the system, it is the reverse repo that the RBI prefers as a credit management tool. It was only during the October 2006 credit policy that the RBI, after a long gap, increased repo rate to control inflation.

As of today, the reverse repo rate stands at 6% and the repo rate is 8.5% . Any monetary authority lends money at a higher rate and borrows at a lower rate. RBI, too, is a clever money manager. It lends money to banks at 8.5% per cent (repo rate) and borrows money from banks (reverse repo rate) at only 6 per cent, maintaining a neat difference/ profit of 2.5 per cent.

How this affects us: Again, if the RBI increases the reverse repo rate, consider it bad news. It means the banks have less money to lend — since they will keep quite a bit of it with the RBI. As a result, we will have to pay a higher rate of interest if we are planning to apply for a loan.

If we are lucky, though, and the bank does not want to lose us as a clients, it may absorb the increased interest and not pass the cost to us. But that generally does not happen and we all know that. Everyone wishes to wash their hands off when the times are difficult.

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Repo (Repurchase) Rate

Repo rate is the rate at which banks borrow funds from the RBI to meet the gap between the demand they are facing for money (loans) and how much they have on hand to lend.

If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.

How this affects us: If the bank is paying a higher rate of interest to borrow money, we are the one who will bear the cost — we will pay a higher rate of interest when we borrow money from them. This is how banks ensure that they continue to make a profit.

For example, let’s say you need money for some reason and you apply for a loan. The bank may have already exhausted all its available money by lending to other borrowers and does not have enough money to lend to you. This does not mean it will refuse your loan request.

The bank will go to the RBI and ask for money. The RBI lends this money to the bank at a fixed rate of interest (the repo rate fixed during the credit policy; the credit policy is announced every quarter). This tool helps the RBI increase the amount of money flowing into an economy (that is, it brings more money, as and when needed, into the banking system).

As of now, the Repo Rate is 8.5%.

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What is meant by Bank Rate?

Bank Rate – This is the rate at which the RBI (India’s Central Bank) lends the money to other banks such as ICICI, SBI, Canara bank and so on. It also lends money to the financial institution such as LIC housing finance and others.

The Bank Rate signals the future of RBI’s interest rates in a long term. If the Bank Rate moves up then the interest also tends to move up and vice versa.

The banks and financial institutions borrow money from the RBI at a lower interest and make profit by lending it at a higher interest rate. Generally the banks borrow money from either RBI or the other banks who have surplus deposits. If the RBI hikes the bank rate, the interest that a bank pays for borrowing money increases. It, in turn, hikes its own lending rates to ensure it continues to make a profit.

How this affects us: If the RBI keeps the bank rate unchanged, we may not really be affected. But if it increases the bank rate, be prepared to pay more for any loan that we have taken from a financial institution.

The bank rate will gives us an idea of the RBI’s long term view of the economy. If the bank rate goes up, it means things are going to get more expensive in the long run.

Bank Rate is at 6% as of now. It has not changed from 2007 AFAIK.

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Can we stop Inflation?

I was thinking about Inflation and thought can we really stop this? I don’t know how far my thoughts are valid but still here are those.

Inflation as covered in my previous articles would give you a rough idea about what is. According to me, people have got enough money to buy products but there are less products present in the market and due to scarcity they are sold in premium. Just because people have more money and willing to pay for that product more, those products are sold at a higher price only because of the demand and nothing else.

How can we stop this? Just think about this scenario. In a village there are 50 people and only 1 shop which sells rice. The shopkeeper buys the rice from a local trader. Trader buys the rice from farmers of a different village for Re. 0.90 per kg and sells to shopkeeper for Re.0.95. Trader can stock at most 2000 kgs of rice in his storeroom on a day. He gets rice from villages only once in two weeks. The shopkeeper can at most stock 150 kgs of rice in his shop.

Each person in Village was buying 1 kg of rice for Rs. 1.10 per day for his consumption, so for every day the rice shop used to sell 50 kgs of rice. Shopkeeper used to get his share from the trader once in 3 days. One day, Shop keeper provides the opportunity for people to buy 10 kgs of rice for Rs.10. Suddenly many were interested in such a deal and wanted to buy 10 kgs of rice, all of a sudden the demand increased but the supply could not be met. Shopkeeper asked for more and more rice and trader gives 500 kgs of rice in 4 days and all the stock is depleted in just 4 days. This was happening as a routine and the shopkeeper decided to increase the price of rice from 1 to 1.25. People thought since there is a huge demand for rice the price is increased and started paying the price for it and started stocking the rice thinking that the price may increase further. Instead of buying 10 kgs people started buying 20 kgs in order to stock it so that they have enough for the next 20 days. Slowly people started stocking more and more and the price started increasing gradually. One fine day it touched Rs. 2. Since shopkeeper was asking for more rice, trader saw this opportunity to increase his price, the farmers also hiked their price since there was a huge demand. AS and when the demand increased the price also shot up.

If we think about this scenario, what can we conclude? Who is at mistake? Most of them would say shopkeeper. I would say its the villagers. If they had not started buying the rice at bulk the prices would have not increased so much. Since they themselves created this situation, they are paying the price of it. If all the villagers had decided to buy just 1 kg of rice daily then there would have been no major difference between supply and demand. It would have been as usual for them.

I think this is how the prices fluctuate and Highly paid professionals are partly responsible for this. Since we are the guys who are ready to pay dearly and stock things and create the price hike for others also to pay. We get paid handsomely and hence it does not pinch our pockets but for a common man it does. I would suggest you to not to pile up things. I am not sure even about its consumption. (People waste most of the food.) This would bring down the prices I guess.

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