The subprime crises triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States ,lead to major adverse consequences for banks and financial markets around the globe. Administered interest rates are one of the major measures for controlling the money supply in an economy. Bank rate, repo rate and reverse repo rate are administered by the Reserve Bank of India. The records show high fluctuation in the interest rates in the past in India. The Reserve Bank of India (RBI) made drastic cuts in interest rates during the recession period to make sure that the banks and individuals get the benefit of higher credit availability. The Government of India had the stimulus package for the India Inc., where as the Banking sector has been successfully managed by RBI measures.
- Meaning of Interest Rates/Policy rates: Interest rates can be defined from different perspectives, for an Individual aninterest rate is the price a borrower pays for the use of money, they do not own. For an Organization, Interest is a fee paid on borrowed funds/assets. It is the price paid for the use of borrowed money or, money earned by deposited funds. For General Banking, An interest rate is the amount received in relation to an amount loaned. An interest rate is the amount received in relation to an amount loaned, generally expressed as a ratio of rupees received per hundred rupees lent. Interest rates can be classified as specific interest rates and interest rates in general. Specific interest rates area interest rates on a particular financial instrument market, these rates are driven by market forces (i.e. Demand and supply). General interest rates, such as bank rate are administered interest rates i.e. re set by some established group (bank rate is administered by central bank of a country, RBI in India).
- Bank Rate,Repo and Reverse Repo Rate: Every central bank functions as a controller of credit in an economy. One of the measures to control credit is by the way of monitoring the bank rate, repo rate and reverse repo rate. Bank rate is the rate at which the central bank (R in INDIA) lends to commercial banks and acts an important benchmark in determination of interest rates charged by banks from the ultimate borrowers. In brief, raising bank rates by raising bank rate, central bank raises the cost of borrowing. This forces the commercial banks to raise in turn the rate of interest from the public and vice versa. Changes in bank rate are generally referred in terms of basis points. A basis point (often denoted as bp) is a unit relating to interest rates that is equal to 1/100th of a percentage point per annum. It is frequently but not exclusively used to express differences in interest rates of less than 1% pa. It avoids the ambiguity between relative and absolute discussions about rates. For example, a “1% increase” from a 10% interest rate could refer to an increase either from 10% to 10.1% (relative), or from 10% to 11%. Similar, are the repo and reverse repo rates. Whenever the banks have any shortage of funds they can borrow it either from Reserve Bank of India (RBI) or from other banks. The repo rate is the rate at which the banks borrow these excess funds. The borrowing bank mortgages its government securities to carry out this loan transaction. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive. Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from the various commercial banks. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to attractive interest rates. It can cause the money to be drawn out of the banking system.
RBI Actions During Global Recession/Subprime Crisis
Since September 2008, RBI has taken multiple actions in order to ensure that the economy does not suffer a massive downturn. The RBI has cut the repo rate by 400 basis points from 9% to 5%, reverse repo rate by 250 basis points from 6% to 3.5% and the CRR by 400 basis points from a high of 9% to the current 5%. Where as the Statutory Liquidity Ratio (SLR) was reduced from 25% to 24%. The RBI has also reprimanded the Banks which have been slow in passing on the benefits of the lower interest rate onto the borrower. It clearly pointed out that the interest rate cuts by the public sector banks have been in the range of 1.25%-2.25%, 1%-1.25% for private banks and 1% for foreign banks. The slackness in passing on benefits to the consumers can be seen in a comparison between reactions of banks to RBI policies in 2004 and 2008. Towards the beginning of 2004 the RBI key policy rates were at approximately similar levels although private banks were charging about 7.5-8% during that time and are currently charging approximately 10-11% for home loans.
The RBI has adopted a comparatively more conservative target of 6%, as compared to the Government’s 7% GDP growth target for the current fiscal, in light of the global downturn resulting in moderation of growth and muted inflationary pressures that are being experienced currently by the Indian economy. The policy announced a cut in repo and reverse repo by 25 bps in order to encourage lowering of lending rates, increased lending and stimulate aggregate demand within the economy in order to mitigate downside risks. After the additional 25 bps cut, currently the repo rate has lowered down to 4.75% and reverse repo rate to 3.25%.There is also a clear indication that the central bank will continue to monitor the economic performance as downside risks continue to persist in the economy and necessary action will be undertaken as deemed favorable which translates to possibly more rate cuts in the short term.
Impact of RBI’s Actions
Lowering of the interest rates would first impact the deposit rates offered by banks as they bring down their cost of funds and then pass on the benefits to the borrowers by lowering lending rates. The impact of lower deposit rates will make fixed income instruments less attractive in the short to medium term. The sharp recent correction in real estate prices that has led to rationalization in property prices has now made real estate a relatively more attractive option. As the fixed deposit rates continue to fall real estate as an asset class will start attracting more investments and become a more preferred investment vehicle.
The cut in both reverse repo and repo is expected to induce banks to reduce their lending rates as seen with the immediate cut in lending rates by certain private banks of 50 bps. This reduction in turn will add more spending power of the borrowers as existing loans get cheaper resulting in increased discretionary income which will start to draw the consumer to spend again and help in boosting demand. The new loans generation will also be done at a lower rate which will in turn increase the borrowers’ affordability. As developers procure additional loans at a lower rate they would be able to pass this benefit on to the end user with lower capital values. The lower lending rates will also result in lower EMI payment resulting in higher affordability, as the interest rates continue to soften in the short to medium term. As per the policy the credit to housing by banks has reduced from 12% on Feb. 15, 2008 to 7.5% on Feb. 27, 2009 from the previous year. Showing the abating demand which has impacted real estate prices resulting in a correction of 20-30% across India from the peak levels established in 2008.
On the commercial real estate front, developers who were facing a liquidity crunch will be able to abate the stringent cash flows as there is already sufficient liquidity in the banking system and as the lending rate reduces, the cost of funds for the developers would decrease leading to improved cash flows. This in turn would help many in completing their unfinished projects and meet their expected deadlines. Although fears in the system remain that adequate lending might not occur to the real estate sector due to risk aversion that has developed by banks to control rising NPAs.
The only dampener to the lower interest rates would be the government borrowings which the RBI has assured will be carried out smoothly with sufficient liquidity in the system being provided. During the first half of the current fiscal year, planned open market operations (OMO) purchases and Market Stabilization Scheme (MSS) are expected to add further liquidity of approximately INR 1,20,000 crore in the financial sector during in the short term. This expected liquidity along with the rate cuts lead to the long term yields falling after the policy announcement and analysts are expecting the long term yield to drop below 6% in the short term. The dropping of long term yields and increasing liquidity is expected to keep the cost of funds relatively low for the banks amounting to lower lending rates in the short to medium term. A regime of similar components namely low lending rates, ample liquidity was found during the year 2003-04 which led to the start of the real estate Bull Run. Thus we find that the seeds for the next growth cycle being sowed in the current downturn.
As experienced in 2002-03 the real estate market remained subdued due to lower economic growth, India is again expected to witness moderate growth during the current financial year which will translate to suppressed real estate prices. International agencies such as the IMF and World Bank etc are pegging revival of the economy in the first half of 2010 and momentum is likely to be gained only in the second half of calendar year 2010. Due to the economic uncertainty with forecast ranging from 5%-7% one cannot presently foresee the start of the next real estate bull run, however, the market is likely to bottom out during the first half of the next financial year, making it apt for the investor to invest in properties at a discounted prices during the year with a long term investment horizon.