Inflation-Certain Economic Terms Explained

Shri.S.Ramakrishnan, Inspector of Customs, Trichy is the author of this article.

Many thanks for positive comments given by GConnect readers for my article on inflation. This is my attempt to explain some more economic terms as desired by readers.CASH RESERVE RATIO, percentage of cash, RBI, Demand liability, STATUTORY LIQUIDITY RATIO,  cash, gold, approved securities, time liabilities, total demand time liabilities, net demand and time liabilities, REPO RATE, REVERSE REPO RATE, Re-Purchase Option, fixed rate of interest, buy back, securities, borrower, PRIME LENDING RATE, PLR, BPLR, Benchmark PRIME LENDING RATE

CASH RESERVE RATIO (CRR)

It is a percentage of cash every bank has to maintain with RBI. The percentage is fixed by RBI. It is calculated based on the net demand and time liabilities of a bank.

Demand liability is a type of liability in which the amount must be paid on demand. For example, Current Account is a demand liability i.e., the bank must pay the amount (a customer wishes to withdraw) whenever he demands the amount he has in his Current Account.

Time Liability is a type of liability in which the amount becomes payable only on a certain point of time in future. For example, Fixed Deposit is a time liability i.e., the bank must pay the amount (a customer has in his fixed deposit) only on the date it gets matured.

The following slide show could explain this term easily.

STATUTORY LIQUIDITY RATIO (SLR)

It is a percentage of cash / gold / approved securities that a bank must maintain with itself before lending to the customers. It is calculated based on the total demand and time liabilities of a bank. There is a difference between ‘net demand and time liabilities’ and ‘total demand time liabilities’. The methods of calculating both are different which are prescribed by RBI.

The difference between CRR and SLR is that in CRR, banks has to maintain Cash balance with RBI whereas in SLR, banks can maintain themselves the prescribed percentage (by RBI) of reserve not only in Cash but also in gold or approved securities. Both CRR and SLR are tools of monetary policy. But the SLR makes banks to invest some portion of money in Government Securities (‘gilt edged securities’) which are totally risk-free. The purpose of both CRR and SLR are to curb the lending ability of banks and suck out excess money from the economy.

REPO RATE AND REVERSE REPO RATE

REPO stands for ‘Re-Purchase Option’. The concept behind REPO is simple. Let us consider there are 2 persons ‘A’ and ‘B’. Let us suppose ‘A’ has got securities (i.e., shares, bonds etc.,) and ‘B’ has cash. ‘A’ wants cash. ‘A’ signs an agreement with ‘B’ stating that

  • ‘A’ will give securities to ‘B’ and get the equivalent cash from ‘B’.
  • ‘A’ will pay a fixed rate of interest to ‘B’ for the cash he borrowed from ‘B’.
  • ‘A’ will buy back (Re-Purchase) the securities (that he gave to ‘B’) at a fixed future date and fixed price.

This arrangement for ‘A’ (borrower) is “REPO” because he has agreed to repurchase the securities he has given to ‘B’ and for ‘B’ (lender) it is “Reverse REPO”. Simply ‘REPO’ and ‘Reverse REPO’ are one and the same viewed for different angles. For who borrows money it is ‘REPO’ and for who lends money it is ‘Reverse REPO’. The same is true for ‘REPO Rate’ and ‘Reverse REPO Rate’. The fixed interest ‘A’ and ‘B’ agree to is ‘REPO Rate’ for ‘A’ and ‘Reverse REPO Rate’ for ‘B’.

In our country, both the ‘REPO Rate’ and the ‘Reverse REPO Rate’ are viewed only from the angle of RBI which fixes both the rates. Hence, when banks give the securities they hold to RBI and borrow money, the interest rate paid by the banks to RBI is ‘REPO Rate’. When the RBI gives the securities it holds to the banks and borrows money, the interest rate paid by RBI is ‘Reverse REPO Rate’. RBI employs both these rates to suck out excess money in short-term. Also for RBI, there is no need to money borrow money from banks. But it does so to absorb the excess money circulating in the economy.

When ‘REPO Rate’ is high, banks will not borrow much from RBI and vice-versa. When ‘Reverse REPO Rate’ is high, banks will find RBI an attractive destination to place their excess money (as RBI will pay more interest to banks).

Watch this slide show for more clarity

PRIME LENDING RATE (PLR)

‘Prime Lending Rate’ or ‘Prime Rate’ is an interest rate banks lend money to their most favoured and credit-worthy customers. In our country (till June 30, 2010), ‘Benchmark Prime Lending Rate’ (BPLR) was followed.

What is the difference between ‘PLR’ and ‘BPLR’?

Simply, there is no major difference between ‘PLR’ and ‘BPLR’. ‘PLR’ was renamed as ‘BPLR’ but the concept remained same .  Then why it is called ‘Benchmark PLR’?  Because, the interest rates bank charge to all other customers must have reference to BPLR, ie., any other interest rates must specify how much percent it is high / low from BPLR.

The problem with BPLR is that more than half of the loans lent by the banks are Sub-BPLR i.e., interest rate below the BPLR. Every bank had its own BPLR and there was no transparency as to how a particular interest rate above / below BPLR was set by a bank. It may be interesting to note that the recent worldwide financial crisis was due to ‘Sub-Prime Lending’.

BASE RATE

Now the RBI has changed the BPLR to Base Rate Regime. Base Rate is a interest rate which a bank can set for itself and can also change it from time to time according prevailing conditions. The major difference between BPLR and Base Rate is that banks could not lend below the ‘Base Rate’. So, the method of computation of interest rate for various sectors becomes transparent.

CASH RESERVE RATIO, percentage of cash, RBI, Demand liability, STATUTORY LIQUIDITY RATIO,  cash, gold, approved securities, time liabilities, total demand time liabilities, net demand and time liabilities, REPO RATE, REVERSE REPO RATE, Re-Purchase Option, fixed rate of interest, buy back, securities, borrower, PRIME LENDING RATE, PLR, BPLR, Benchmark PRIME LENDING RATE,  BASE RATE, indian banks

Effect of reduction in Base Rate:

CASH RESERVE RATIO, percentage of cash, RBI, Demand liability, STATUTORY LIQUIDITY RATIO,  cash, gold, approved securities, time liabilities, total demand time liabilities, net demand and time liabilities, REPO RATE, REVERSE REPO RATE, Re-Purchase Option, fixed rate of interest, buy back, securities, borrower, PRIME LENDING RATE, PLR, BPLR, Benchmark PRIME LENDING RATE,  BASE RATE, indian banks

The views expressed in this article are those of the guest author and are not intended to represent the views of GConnect.

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