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Sunday, November 2, 2008

What the CRR-SLR-Repo cuts mean for investors

Economics and monetary matters are not my strength areas, but a lot of investors must be wondering how all these different rate cuts may affect them. So here is a 'dummies guide' to the triple rate cut dose.

But first, some of the basics.

The Repo rate is the rate of interest charged by the Reserve Bank of India (RBI) to commercial banks who may need to borrow some short term funds against securities. (The Reverse Repo rate is the rate of interest paid by the RBI to the banks who may park short term funds with it. Usually the RBI pays a lower rate.)

The Cash Reserve Ratio (CRR) is a percentage of the total deposits with commercial banks that they need to keep with the RBI.

The Statutory Liquidity Ratio (SLR) is a percentage of deposits that commercial banks need to invest in government securities.

What purpose is served by such means? It is for the safety and security of the funds available in the banking system (which in turn helps investors like you and me). It is also for controlling the supply of money (or liquidity) in the country's financial system.

The Foreign Institutional Investors (FIIs) were lured by the growth prospects of the Indian economy and brought in huge funds (by Indian standards) to purchase shares of Indian companies. Indians working overseas also channeled money back to the country for investments because of the comparatively higher interest rates.

As demand for products and services kept rising, capacities got stretched, and prices were hiked. Industries went in for capacity expansion availing cheaper overseas funds. With higher production the GDP kept rising, attracting more foreign funds.

The increased liquidity - mainly from overseas - and higher prices caused inflation to rise. Initially the government kept ignoring the rising inflation rate till it hit double digits. To curtail inflation, the RBI squeezed the supply of money by gradually increasing the CRR, SLR and Repo rates.

Unfortunately, the sub-prime crisis in the USA hit the world's financial system like a whirlwind. Many of the FIIs who had lost heavily in the sub-prime derivatives markets, started to sell aggressively in the Indian share market.

The outflow of foreign money caused two problems. First, it caused a reduction in liquidity - which had already been tightened by RBI's policies. Second, it caused a fall in the value of the Rupee - which the RBI tried to stem by buying foreign currency, further reducing liquidity.

The banks started feeling the pinch and started offering higher interest rates for deposits and, therefore, charging higher interest rates to borrowers.  Industry found the easy-money taps getting closed - both in India and overseas, and started slowing down their growth plans.

Speculators who borrow money to invest felt the cost of doing business was too high and started selling off. This compounded the selling pressure already exerted by the FIIs. The downward spiral in the stock market got exacerbated when small investors also started selling off.

The several rate cuts over the past couple of months is the RBI's and governments rather belated effort to inject liquidity in the market so that banks can resume lending. Hopefully that will lead to rejuvenating the growth plans of industries and eventually lead to reduction of interest rates.

That would be the first indication that the stock markets are ready to stop falling and starting their next upward journey.

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