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Is The RBI’s Move Good For India?

December 20, 2013
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Is RBI's step justified? Is the cautious step a state of defense or an act of wit?.

What do you think? Should we try to understand this a little better? Well, let's go ahead and do that! Maybe our understanding of the entire situation will be a bit clearer.

First things first: these thoughts are not new. They have been going around in the heads of leading economists all across India, especially as the RBI leaves the short term lending rate at the same value as the previous.

Analysts had speculated that the rates would follow a pattern similar to the last two occasions and observe a rise yet again. The economic crisis that India is experiencing at the moment as well as the ever-rising rates of inflation forced every economist to expect soaring lending rates yet again. The rise was supposed to be 0.25%. But the unexpected happened as RBI stunned everyone. Interest rates have been held at 7.75%.

Funny how things don't turn out quite the way you'd expect them to! Here is a graph to elucidate the point I am trying to make.

Let me first introduce the concept of short term lending rate or repo rate to our nascent readers.

If banks are short of funds, they can borrow rupees from the Reserve Bank of India (RBI) at the repo rate, the interest rate with a 1 day maturity. If the central bank of India wants to put more money into circulation, then the RBI will lower the repo rate.

Now that we know what repo rates are, let us proceed further..

According to the Central Bank of India, the driving force behind this decision is the fact that food prices are expected to fall soon and the effects of previous hikes have not been felt yet. A press release from RBI said, "Given the wide bands of uncertainty surrounding the short-term path of inflation from its high current levels and given the weak state of the economy, the inadvisability of overly reactive policy action, as well as the long lags with which monetary policy works, there is merit in waiting for more data to reduce uncertainty."

The defensive stand of RBI is well appreciated across the nation. Clearly, RBI is willing to wait before taking any step further along the lines of changing repo rates. Logically, in times of high inflation and slow growth, policies have to be formulated cautiously. However, it is also evident that if the speculated downfall in the food prices does not happen and inflation is not checked, RBI will most definitely need to take action.

Over the past few years, interest rates have not shown any absolute trend but have fluctuated as depicted. It is interesting to note that the Indian market has also shown similar kind of trend in the past few years..

Such astonishing similarity can be explained as follows: when the repo rate falls, bond prices go up and market comes down. Markets have optimistically accepted the maintained repo rates even this time around. On the day of declaration of rates, BSE Sensex rallied up 1.1% and Nifty also observed a 1.2% rise. On the same grounds, the rupee has appreciated against the dollar with numbers reaching Rs 61.82 per dollar on Tuesday, with a closing rate of 62.01. RBI's step has attracted many FIIs in to the Indian markets as well.

Another interesting theory that I have observed is that when it comes to the real rate, India accounts for the lowest amongst its peers.

It isn't easy to make a smooth, calculable explanation. You and I can only make analyses based on our various assumptions and our own understanding of India's economy. But again, all the factors that are taken into consideration can change by the hour! So, let's wait and watch to see what happens next!

If you want to present your own points of view, please post them in comments section below!


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