Bank Rates- a conundrum

More often than not, the central bank of a country (in India, the Reserve Bank of India or the RBI), grapple with the question of positioning of the repurchase rate (repo rate). The COVID pandemic has brought about quite a drastic reduction in the economic activity of the country, and to address the slowdown and to stimulate growth, the RBI has stepped in. To simplify the concept, I would like to breakdown my understanding of this important subject as under.

Repo rate is a key monetary policy of the RBI, wherein the interest at which it lends funds to commercial banks is set. A low repo rate is aimed to increase money availability with the commercial banks so that they can lend more to businesses with the purpose to increase economic activity. In other words, it is hoped that with lower cost of capital, businesses would borrow more money from commercial banks and the purpose of which, would be to invest in growth.

The central bank’s recent reduction of their benchmark repo rate, which, when coupled with a rise in consumer prices, has led to real interest rates becoming negative. This step comes as a bid to disincentivize savings and increasing spending.

Firstly, what is real interest? Real interest is the difference between nominal interest rates and the inflation rate (Real interest rate= Nominal interest rate-Inflation rate). It reflects the real cost of funds to the borrower and the real yield to the lender or to an investor, and is a reflection of the change in purchasing power derived from an investment or given up by the borrower. So, what does a negative real interest rate imply? A negative real interest rate means that the cost of borrowing is lowered, and at the same time reduces the interest received by the public on their savings. To illustrate this point, let us take an example. If a bank loans a person Rs.1,00,000 to buy a car at a rate of 4%, the nominal interest rate (not factoring in inflation) is 4%. Assuming the inflation rate is 2%, the real interest rates the borrower is paying is only 2%. The real interest rates the bank is receiving is 2%, which means the purchasing power of the bank only increases by 2%.  As of June 2020, consumer prices have risen to 6.09% in June due to the corona virus affecting the supply side. The RBI have also cut repo rates 1.15% between March and May, to a current rate of 4.00%. This means that commercial banks are also lending at a lower rate (as the rate at which RBI offers short term loans has decreased), leading to a situation of negative real interest rates.

But what are the implications of the real interest rates being negative? Having negative real interest rates is a way to compel people to shift their money from savings accounts in banks to other investments, where the yield is much higher or alternatively to increase spending. In this way not only will  the investments in the country rise but the consumption will also rise  leading to an increase  in aggregate demand, which is the need of the hour in these corona hit times. This would then hopefully start a positive chain of events, resulting in the economic growth nudging northward.

However, there is a negative side to negative real interest rates. This measure almost forces the hand of the populace, forcing them to withdraw money from their savings and trying to find other high-risk investments with higher yield, but without the same guarantee offered by banks. This might especially affect the older, retired generation, who depend on this interest as their income.

Another disadvantage could be  flight of capital from the country. In this situation, large multinational corporations  may choose to move funds overseas. This obviously is the opposite of the intention with which such a strategy was implemented in the first place. However, in such uncertain times, such measures are required to get the ball rolling and to try and spark a recovery in the economy. Such measures are short term as stated by the RBI themselves and are merely a shot in the arm in an attempt to boost the demand side of the economy. Challenging times call for unique measures, and we remain optimistic  that this strategy pays off.  Nothing risked, nothing gained.