The repo rate has been increased by 25 basis points from 7.25% to 7.5% and the bank rate also known as the MSF has been reduced by 75 basis points from 10.25% to 9.5% by the RBI. “The need to anchor inflation and inflation expectations has to be set against the fragile state of the industrial sector and urban demand. Keeping all this in view, bringing down inflation to more tolerable levels warrants raising the repo rate by 25 basis points immediately,” says the RBI in its mid-quarter policy review statement.
However, the market and captains of industry responded quite negatively with the Sensex shedding 600 points on the day the interest rate changes were announced by India’s chief central banker. Director General, Confederation of Indian Industry (CII) Chandrajit Banerjee said that “CII is fully appreciative of the RBI’s concern on inflation, but as we have been pointing out all along, this is a supply side led issue and therefore, at this point of time, growth should have found priority for the central bank.”
Vijay Kalantri, President, All India Association of Industries (AIAI) was critical of India’s central bank stance, stating that “the increase of 25 bps of repo rate will not reduce the liquidity of the banks and will hardly be a tool to combat the inflation which is hovering between 9-11 per cent. Inflation can only be reduced if productivity gets impetus.”
UNDERSTANDING THE REPO
Repurchase agreements, or repos, are transactions in which a borrower (banks) “sells” securities to a lender (RBI / Central Bank) and agrees to purchase it back for at a specified price on a later date. Most repos are overnight transactions between financial institutions and are primarily used in money markets. In effect, a repo is a secured loan since the lender gets a collateral for the cash being lent out – the only difference is that the ownership of the collateral is transferred (to the lender (Central Bank)) in the case of repos, whereas under a loan the borrower retains ownership of the collateral. The difference between the selling price and the repurchase price is the effective interest rate in these transactions.
The repo allows banks to borrow from the Central Bank to the extent of 0.5 % of their liabilities. For further requirements the RBI loans out money to banks met via the Marginal Standing Facility (MSF) window subject to a limit of 2 % of their liabilities. Analysts estimate that the MSF and the repo account for about 55 per cent and 45 per cent respectively of bank borrowing from the RBI. Typically, a cut in the MSF rate only impacts short-term interest rates which are very crucial for a firms working capital costs. Long-term lending rates are influenced by the cascading effect of the repo rate.
INTEREST NOW A BLUNTED TOOL
While attending an event to receive the Deutsche Bank Prize in financial economics, RBI governor Raghuram Rajan acknowledged the futility of banks using interest rates as a lever for stimulation by saying, “We seem to be in a situation where we are doomed to inflate bubbles elsewhere. We should wonder whether lower and lower interest rates are in fact part of the problem, I say I don’t know. It (interest rate tool) is very, very blunt … targeted fiscal policy may be better.” This reading is well corroborated by the state of affairs in the biggest economies of the world like the US and Japan where the short-term nominal interest rate is zero or just above zero causing a liquidity trap and limiting the capacity that the Central Bank has to stimulate economic growth.
Forget debt, it’s time to use equity to drive investment
Classic finance theory states that for companies seeking capital to grow, debt is better since it’s a cheaper form of financing than equity. You take out a loan for a period of time, you either pay (or accrue) interest over the life of the loan, and then you pay it all back – it’s done, it’s off the books, and your debtors go away; whereas equity is considered expensive since you are selling shares and the equity buyers may hold such shares forever. Debt is thus a cleaner structure, and assuming you can put the loan to work in a way that generates a higher return than the interest you pay, debt is typically the preferred way to finance growth.
However, what is conveniently forgotten is that in case of a default the bank continuously receives profit on its principal and the rate of profit goes on increasing with the passage of time. Thus liabilities for business keep growing exponentially damaging the entrepreneur-climate and spirit irreparably and stifling new ventures and enterprise. Growth naturally suffers and you have recessions and depressions causing mass unemployment. Secondly, the equity based investor is a true partner in both the profit and loss of business and takes his share in proportion to the volume of the profit. Debtors on the other hand claim a fixed rate of profit irrespective of the outcome of business and so this is a very unequal and unjust partnership which will always lead to mutual hatred and mistrust. Moral of the story: usury kills growth while equity spurs business and stimulates the economy without any externalities attached.
TIME FOR A REALITY CHECK
We pride ourselves as a society that cherishes freedom, equality and justice. We detest slavery, inequality and injustice. And yet the more you study the way the banking industry is controlling and strangling the global economy, the more you realise that the root cause is the deliberate and diabolical lack of application of universal laws of justice and fair-play in the way various financial instruments and policies have been designed and framed by those controlling the levers of international finance.
The first step to come out of this quagmire itself is quite daunting – do a reality check – understand what is going on and how? The complexity and sophistication of the various financial systems and products make it virtually impossible for the common man to visualise that there could be an alternative to contemporary economic approach and there are people who have the capability and ideas to deliver them from the noose of economic exploitation. For a start however – a walk around the sukook market might help.
[The writer is a Pune based professional and can be reached at bismillah@gmail.com]