CRR Cut: Effect on Industry, Economy and People

RBI is meeting on Jan 24th to conduct normal open market operations ( OMO ). The market hugely expects that RBI will cut CRR by some basis points. So what does this mean to normal people ? Does the interest rate on home loan, auto loan etc., come down ? To answer this let's look at what CRR means.

CRR is the ratio of money the bank needs to keep for every rupee of deposit that customer keeps with the bank. For example: If investor "A" keeps Rs.100 in the bank "A", and CRR is 10% then bank "A" must keep Rs.10 as the reserve and can lend the remaining Rs.90 to customer "B". If the customer "B" deposits this Rs.90 in another bank "B", then bank "B" can lend Rs.81 to customer "C" and must keep Rs.9 in their vault. So this craziness goes on and essentially (1/CRR) [ Money Multiplier] *Inital Deposit i.e., in our case 100*10 = Rs.1000 of new money is created for every Rs.100 (hard currency) deposit a customer makes in the bank. To summarize, a CRR cut would basically allow banks to take the money they have kept as reserves and lend it to customers and thus increase the money supply in the system.

 Having understood what CRR is, now let's try to know how is it would affect normal customers, banks and corporations ?

Withdrawal:

Normally, banks don't have all the deposit money customers have made in their bank as they would have lent it to other customers. However, they have enough money ( based on their forecasting) to honor the per day withdrawal commitments. If the withdrawals are more than their forecast (assuming their liquidity is low) they borrow from RBI paying interest rate ( Repo Rate) by pledging their assets ( Bonds) or borrow from other banks paying interest rate (Call rate). This borrowing by paying interest rate ( Repo Rate or Call rate) reduces the profitability of the banks relatively.

Loan:

Loans are the primary way banks make tons of money. They borrow from RBI at lower rates and lend them to customers at higher rates and make profit. This is a simplistic explanation of how banking system works. Should the bank need to loan to corporates or customers and their liquidity is low, they borrow from RBI or other banks by paying interest, in the form Repo or Call rate.

But now, due to the cut in the CRR, immediate new money is available to the banks (from their reserves) which makes them liquid. Instead of going to RBI or other banks to honor withdrawal commitments or loans, they can do it internally without paying interest rate to banks or RBI, thus increasing the profitability of the bank relatively and making more money available in the system to lend.

This has following affect on banks, customers,corporates, bond market and share market::

Normal Customers:

Chances that interest rates of all types would go down, it will be based on individual banks and their liquidity.

FD rates will stop going up.

Loans for individuals and corporates would be easily available.

Banks:

Profitability of banks would increase (as described above)

Stock Prices:

Banks, Auto, Capital goods, Real estate stocks would go up due to lower interest rate payments flowing out and also more demand from retail customers.

Bonds:

Infra bonds:

Yields on Gsec and other bonds will go down. Hence, going forward, mostly, all the tax savings infra bonds would offer lower interest rates. If you want to invest in tax savings infra bonds, do it now, before the CRR cut. 

Fiscal Deficit:

Government's Interest payments would be reduced due to lower interest rates and hence fiscal deficit would go down.

Fixed Income Funds:

Fixed income funds would perform relatively better, especially Gilt funds.

To summarize, the CRR cut would greatly benefit everyone.