The Explainer: Interest Rates
The RBI Governor, Dr Raghuram Govind Rajan, is on his way out. He deserves a
lot of credit for bringing inflation under control and focusing on the massive
non-performing assets (NPAs) of public sector banks.
Various quarters (like the finance
ministry, industry, home-owners) have pilloried him for ignoring their
demands to cut interest rates. In fact, this particular action has drawn the
ire of many (like Dr Subramanian Swamy) who accuse him of sabotaging the Indian
economy by deliberately keeping the interest rates at a higher level.
In this context, this short Explainer will
focus on Interest Rates.
What is Bank Rate?
This is the rate of
interest charged by the Reserve Bank of India (RBI) on long term loans made to the commercial banks (like State Bank of
India).
What is Repo Rate?
This is the rate of interest charged by
the Reserve Bank of India (RBI) on short term loans made to the
commercial banks.
What is Reverse Repo Rate?
This is the rate of interest charged by
the commercial banks on short term loans made to
the RBI.
The Central Government has been nudging
the RBI, albeit unsuccessfully, to cut interest rates. In this
context, it should be understood the Central Government wants the Repo Rate to
be reduced. Why?
A reduction in Repo Rate would mean that
the commercial banks would have to pay a lower rate of interest on money
borrowed from the RBI. The commercial banks could pass on this benefit to
commercial borrowers (like us); this would lead to a fall in the rate of
interest paid by us to banks (on loans). Thus loans become cheaper,
meaning borrowing becomes less burdensome and thus more attractive.
How does that help me as an individual? As an individual, the interest you pay on a loan (of
any kind) will come down; consequently, you will save more and may use that
(saved) money in either further savings or buy some stuff (like consumer
durables). This in turn will spur demand for goods and services.
Does this help business? Now, if you are a businessperson, you could
borrow more (at a lower rate of interest) and invest more in the business. As
you invest in higher production capacity, you employ more people - this leads
to higher job generation - translating into higher demand for goods and
services, which in turn pushes up industrial production. As you see, this is a
virtuous cycle.
In short, lower interest rates push up
economic output, leading to higher economic growth.