RBI’s First Steps in Killing the Liquidity In The Indian Market.


The RBI has increased the repo rate of the banks by 40 points basis and Cash Reserves Ratio by 50 points basis on May 4, 2022. The Repo Rate is the rate at which the central bank gives out the loans to the Commercial Banks. Cash Reserve Ratio is the minimum percentage level of the cash out of the total deposits that banks need to keep with themselves. This was the first time since August 2018, that the RBI has increased the CRR and Repo Rate. But Why Did They Do So?

The simple answer to that question would be to reduce the Inflation in the Country. The Inflation in the country is increasing beyond the bearable inflation band of RBI (4%-6%), which is leading the price to increase at exponential rates. The question arises, how is increasing the repo rate and cash reserve rate will decrease the prevalent inflation in the country?

Increasing the Repo Rate will cause the banks to pay more interest on the money that they borrow from the central bank, since the bank needs to pay more interest to the RBI, the banks will also charge more interest from the borrowers, in turn making the money expensive for everyone. Since that money is now expensive, fewer people will spend it thus reducing the flow of money in the economy.

Increasing the Cash Reserve Ratio will also have a similar effect. An increase in Cash Reserve Ratio means that the Banks will have to keep more money with themselves in the form of Cash, which would decrease their base of money that is available for giving out loans. As a result, banks would have less money than they would give out fewer loans, decreasing the flow of money in the economy.

Implications of this move would be that the Cost of Borrowing would increase for both Corporates and Individual Borrowers. In terms of Corporates, it would turn out as an Increased Cost Of Debt, resulting in higher financial obligations and which would lead to slow growth. As in the case of Individual Borrowers, this would decrease their spending capacity by limiting their borrowing capacity which would lead to decreased consumption, leading to a lowering of the demand.

As for the Stock Market, it is not a good news. As the liquidity in the market shrinks, investors can take the money out of the market due to lower growth expectation due to higher interest obligations of the companies to park their money elsewhere, which could result in fall in the price of stocks.

In conclusion, this move of RBI would lead to a shrink in the liquidity in the economy, which could possibly hamper the growth of the companies in the short-run. However, it is a necessary move to control te inflation in the long run.