Inflation has been sticky here in India for a very long time now. Rising prices of food articles, fuel, power, and commodities have disturbed a common man's monthly budget. To curb these inflationary pressures, Reserve Bank of India (RBI) has kept its interest rates high and looks like RBI's efforts have finally started to bear some fruits.
RBI is ready with its half-yearly monetary policy to be announced on October 30th. As the inflation is taking a breather, if not falling drastically, and the economic growth numbers are plunging to some unexpected low levels, people are expecting RBI to cut some of the key policy rates this time.
Here are some of the measures that RBI uses to control the money flow in the financial systems:
Repo Rate is the rate at which commercial banks borrow money from the RBI for a short period of time. Banks sell their securities or financial assets to the RBI with an agreement to repurchase them at a predetermined price at a future date. A high Repo Rate deters the banks to raise funds from the RBI, forces banks to keep their own lending, and deposit rates high and hence, keeps money supply in check.
Higher interest rates normally curtail investments, as a result of which the overall consumption and aggregate demand fall. Lower demand results in lower resource utilisation. When resource utilisation is low, prices and wages usually rise at a more modest rate. RBI purposefully reduces Repo Rate as and when it wants to encourage banks to borrow money for further lending to spur investments.
Reverse Repo Rate is the rate at which banks deposit their excess money with the RBI for a short period of time. RBI lowers the Reverse Repo Rate whenever it wants to raise liquidity in the banking system for further lending and to raise overall investment levels and hence the aggregate demand. It also makes banks to offer lower rate of interest on the deposits made by the general public. But, at the same time, it allows banks to lend at a lower rate.
Cash Reserve Ratio (CRR) is the percentage of a bank's total deposits which the bank is required to maintain with the RBI. Banks are mandated to deposit this amount with the RBI on a fortnightly basis. CRR is a tool used by the RBI to control the liquidity in the system. So, when there is excess money floating around in the system, RBI will raise the CRR to suck out the excess money. On the other hand, if there is a credit crunch, RBI cuts the CRR to release money into the system. CRR cut increases liquidity in the system to a marginal extent.
Statutory Liquidity ratio (SLR) is the proportion of deposits that banks are required to maintain in cash or gold or government approved securities. Similar to CRR, a reduction in SLR also increases some money supply in the financial system. After keeping the required amount for CRR & SLR, the banks are free to use the remaining deposits for their lending purposes.
Impact on Your Fixed Income Investments
Market-linked investments like Gilt Funds, Income Funds, Tax-Free Bonds or NCDs -
There is an inverse relationship between interest rates and bond prices. When interest rates go up, bond prices fall and when interest rates fall, bond prices rise. RBI's policy measures impact your market-linked investments like Debt Mutual Funds, NCDs and Tax-Free Bonds. The value (or market price) of these investments goes up with a cut in the policy rates. The higher the quantum of rate cut and the more unexpected it is, the more will be the jump in the value of your investments.
Investments in gilt funds, which in turn invest in government securities (G-Secs) primarily, and investments in income funds, which invest in corporate bonds primarily, could give higher returns to the investors as the interest rates decline and their prices go up. Your direct investments in Tax-Free Bonds or corporate NCDs also appreciate in value due to a cut in the RBI's policy rates and a subsequent fall in their yield to maturity (YTM). This results in a gain in your overall bond portfolio.
Investments like Bank FDs, Company FDs or Post Office Schemes - A reduction in RBI's policy rates does not affect your investments in FDs or Post Office schemes at all because these investments are not market linked and the interest rates, you are eligible to get, do not change. But, at the same time, it signals a likely fall in the interest rates on these FDs in the times to come.
So, if the RBI announces a rate cut in its monetary policy and you are planning to invest in bank FDs, then just book it as soon as possible at a higher rate of interest before your bank cuts interest rates on its deposit schemes.