Why Cash Flow Issues Remain Despite RBI’s Repo Rate Cuts

RBI has repeatedly said that despite them reducing their rates, banks have not been passing on the full benefits.

RBI has reduced the repo rate by half a percent this year. But the same reduction hasn’t been reflected in your home or auto loan rates.

Repo rate is the rate at which the banks borrow from RBI for a short term. So if, with lower repo rates, the banks are getting cheaper loans, why have your home and auto loan interest rates reduced in the same way? Now banks claim that their hands are tied due to low liquidity rate, i.e. cash and deposit, in the system. Because of this, they are unable to pass on the full benefits of the RBI’s lower rate to the customer.

Low Cash a Hindrance

Liquidity means the available cash and reserves within the banking system, i.e. the banks. So when the banks say that they do not have enough liquidity, it means that the demand for loans is increasing faster than the funds they have coming in.

Due to higher deposit rates and lack of cash in the system, the cost of funds remains high for them – although, this is nothing new. The RBI has been struggling with this issue for a long time now.

It has repeatedly said that despite them reducing their rates, banks have not been passing on the full benefits to customers.

Cash Flow Issues to Remain Till Elections

This lack of liquidity has remained in place ever since infrastructure group IL&FS defaulted on their loan in September last year. Due to the government reducing expenditure and payments of the Goods and Services Tax, this deficit reached Rs 1.6 lakh crore in April of this year, which was Rs 90-95 thousand crore at the end of the month.

At the very least, this issue will remain till the end of the Lok Sabha elections. In a report tabled in the last week of April, State Bank of India stated that a deficit of Rs 75 thousand crore to Rs 1 lakh crore in cash will remain till the end of the general elections.

Reserve Bank’s Initiative

Although the Reserve Bank has been trying to increase the flow of cash from its side, it has created a plan to put Rs 40 thousand crore in the banking system through the Open Market Operations (OMO) till August this year. In May, it is going to add Rs 25 thousand crore to the banking system through this route. Under OMO, RBI increases the supply of cash by buying government bonds.

The Effect of Cash Shortage on Growth

Reducing the shortage of cash is also necessary to increase GDP growth. When there is surplus cash, banks are able to give cheaper loans. This in turn leads to an increase in demand for goods and services, which means that there is an increase in consumption, which is the backbone of the country's economy.

Companies also increase additional production capacity when loans are cheaper. This increases private investment, which has an important role in increasing the economic growth rate.

Rate Reduction in June?

Keeping this in mind, the Reserve Bank has reduced the repo rate twice this year. The first time around in February, it reduced it by 0.25 percent. After that it similarly deducted the policy rate in April.

In spite of all this, the economic growth rate in 2019 is going to be the lowest since Narendra Modi came to power.

According to the second advance estimate of the Trial Statistics Office (CSO) in February, GDP growth could remain 7 percent in the last fiscal year. Therefore, it is believed that the Reserve Bank of India can cut another 0.25 percent in the repo rate in the June monetary review.

Why Increasing Liquidity Is Important

But just this isn’t enough. In order to increase consumption, private sector investments and cheaper loans the central bank will have to overcome the shortage of liquidity. For this it has recently also launched a dollar-rupee swap program. But so far at least this has not overcome the cash shortage issue.

Under the dollar-rupee swap program, the Reserve Bank buys dollars from banks for a fixed period of time and pays them in rupees. The bank promises to buy back the same amount of dollars from the Reserve Bank when the period is up.

Suppose this period is three years. In that case, the supply of rupee will increase during these three years through this program.

If Government Expenditure Increases

Due to the rising expenditure of the government, there is a fear of increasing difficulties in liquidity management.

If the new government borrows more from the market then there will be a shortage of funds for private companies. This will have a negative impact on growth, which has been happening for the past few years.

Companies have higher production capacity than there is demand. Therefore, they have not invested in increasing their production capacity during this period. This has negatively impacted growth. Due to the danger of El Nino this year, there have also been doubts about regular rainfall in monsoon.

Low rainfall and rising crude oil prices, can increase inflation in the country, the signs of which can already be seen in the rising price of food grain and vegetables. Rising inflation will make it difficult for RBI to reduce loan rates, which will be a double whammy on the economy.

(Nisha Sharma is a regular contributor to Hindi Quint. This is an opinion piece and the views expressed are the author's own. The Quint neither endorses nor is responsible for them.)

(Disclaimer: This piece was originally published on Hindi Quint, and has been translated into English by Mariam Shaheen.)