Repo, Reverse Repo, Bank Rate, Call Rate, CRR & SLR Definitions

As requested by Payal, we are explaining the different rates in monetary policy used by RBI

Repo (Repurchase) Rate

Repo rate is the rate at which banks borrow funds from the RBI to meet the gap between the demand they are facing for money (loans) and how much they have on hand to lend.

If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.

Reverse Repo Rate

This is the exact opposite of repo rate.

The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate. The RBI uses this tool when it feels there is too much money floating in the banking system

If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk)

Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy

Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected.

Bank Rate

This is the rate at which RBI lends money to other banks (or financial institutions .

The bank rate signals the central bank’s long-term outlook on interest rates. If the bank rate moves up, long-term interest rates also tend to move up, and vice-versa.

Banks make a profit by borrowing at a lower rate and lending the same funds at a higher rate of interest. If the RBI hikes the bank rate (this is currently 6 per cent), the interest that a bank pays for borrowing money (banks borrow money either from each other or from the RBI) increases. It, in turn, hikes its own lending rates to ensure it continues to make a profit.

Call Rate

Call rate is the interest rate paid by the banks for lending and borrowing for daily fund requirement. Si nce banks need funds on a daily basis, they lend to and borrow from other banks according to their daily or short-term requirements on a regular basis.

CRR

Also called the cash reserve ratio, refers to a portion of deposits (as cash) which banks have to keep/maintain with the RBI. This serves two purposes. It ensures that a portion of bank deposits is totally risk-free and secondly it enables that RBI control liquidity in the system, and thereby, inflation by tying their hands in lending money

SLR

Besides the CRR, banks are required to invest a portion of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements. What SLR does is again restrict the bank’s leverage in pumping more money into the economy.

 

VAT and refund issues

We had received a query from a student, Neha in which she could not understand the meaning of an Economic Times article.

http://economictimes.indiatimes.com/Market_News/VAT_rate_Exporters_upset_with_Centre/articleshow/2757378.cms

The meaning is explained as follows:

Refund of any tax is the refund of overpaid taxes from the government to the taxpayer. Refunds are due when the taxpayer has been over-withholding or has overestimated income or underestimated deductions, exemptions, and credits.

About VAT

VAT works on the principle that when raw material passes through various manufacturing stages and manufactured product passes through various distribution stages, tax should be levied on the ‘Value Added’ at each stage and not on the gross sales price. This ensures that same commodity does not get taxed again and again and there is no cascading effect. In simple terms, ‘value added’ means difference between selling price and purchase price. VAT avoids cascading effect of a tax.

Sales Tax is a State subject. Over the period, many distortions had come in taxation due to unhealthy competition among States by giving sales tax incentives and ‘tax rate war’ started to attract more revenue to State.

Introduction of VAT is difficult in India as sales tax is a State Subject and sales tax on sale within the State can be levied only by respective State Government. Even in respect of Central Sales Tax (CST), though the tax is levied under Central Act, the CST is collected in the State from which goods are sold, i.e. originating State and CST so collected is retained by that State only. The CST amount never goes to Union Government.

After lot of persuasion by Central Government, all States ultimately agreed to introduce State Level sales tax VAT at the conference of Chief Ministers all States at Delhi in November, 1999. A high power committee consisting of senior representatives of all 29 States was constituted under Chairmanship of Dr. Asim Dasgupta, Finance Minister, West Bengal. It was decided to introduce Sales tax VAT w.e.f. 1-4-2002. It was delayed on several occasions and finally, all State Governments (except UP, Tamil Nadu and few other States) introduced State Sales Tax VAT w.e.f. 1-4-2005.

States ruled by BJP like Gujarat, Chhattisgarh, Jharkhand, Madhya Pradesh and Rajasthan had not introduced VAT. They have introduced Vat w.e.f. 1-4-2006. Tamilnadu has introduced Vat on 1-1-2007.

Uttar Pradesh and Uttaranchal also have not introduced VAT

In this article, it is written that the exporters are not happy about the Central government’s idea to increase the rate of VAT, especially because they have not even received their due refunds from the respective state governments. It highlights that apart from Andhra Pradesh, Gujarat, Tamil Nadu, Punjab and Maharashtra, non-payment of VAT refunds to exporters remains an worry in majority of states, especially in West Bengal and Orissa.

As shown in our article on the rise of the rupee, exporters are already under the hammer because of currency appreciation. Now, if the VAT rate itself is increased, given that due refunds haven’t seen the light of the day, it will prove to be very harsh on the exporter community. As suggested in the article, an increase in the tax rate should also be accompanied by a corresponding mandatory refund requirement. And in this the Centre should take the initiative by punishing the defaulter states by withholding plan allocations.

 

Oracle 29 Jan – 5 Feb

Hello students,

The third edition of Oracle is now out. You can download it here:

oracle-3.pdf

 

National Institutes

In this section we are putting up vital facts students need to cover especial for the prelims exam.

Here we are uploading a list of National Institutes, about which questions are frequently asked.

national-institute-of-importance2.pdf

 

Fed Cut and Impact on Indian Economy

We received a query regarding the Fed cut and its possible impact on the Indian Economy. So we are posting a response to this question. Any doubts regarding this topic, you may ask us immediately.

Interest Rates and their Role

A Basis Point is 1/100th of of one percent. A Basis Point is generally used in reference to interest rates and additions or subtractions done to interest rates. To put it simply if a central bank changes interests rates by 75 basis points, it means that the change is of 0.75%.

Now, let us see what are interest rates. Suppose you have a certain amount of money. Now you want to lend it to someone. To do that, u have to let go of some things you could have done with that money. Eg – with Rs 10,000 you might have wanted to add some accessory to your PC, but now since you will lend that money, you will have to forget it for some time. So you will demand some price of it, won’t you? This price is the interest rate which the lender gets from the borrower. If you charge an interest rate of 10% on Rs. 10,000 annually, you will get an additional interest payment of Rs. 1,00o(10% of Rs. 10,000).

Now think of a lender and borrower in an economy. Where does the money come from? In India, it is the Reserve Bank of India that prints money. It gives that money to banks who further lend it to end-consumers like you and me. That is how money simply flows in an economy. Now RBI gives the money to banks at a certain?? – yes, interest rate. The banks in turn lend it to consumer at a higher interest rate to earn profit.

Now a central bank has to keep in balance a lot of things. It has to keep prices in an economy under control – i.e. inflation, It has to maintain a favourable Exchange Rate, and finally it has to to maintain all the conditions of growth intact.

It does it through many instruments, one of which is controlling interest rates. Now, what reductions or increases of interest rates do to an economy. Lets have a look.

If you INCREASE the interest rates, that means the money in the economy will be available at a HIGHER cost. This means that the demand of money will be LESSER, because, as a borrower, one will have to shell out extra money as interest. Simple rule of demand. When price of anything increases, its demand decreases. So people will demand lesser money, (simply put, people will have lesser money in their hands) which will in turn, reduce the demand of general goods and services in the economy. And as an effect, the prices of these goods and services decrease because of the lower demand.

So the cycle goes like this:

Increase Interest Rate – Money becomes costlier-Lower demand of money-Lower demand of goods and services- Lower prices of goods and services- Lower inflation

Also, higher interest rates will attract investment in the form of capital flows into a country which will have its effects. We will come to that later

Now, a central bank would INCREASE interest rate when a country is facing high inflation. Pretty simple isn’t it?

On the other hand – if you DECREASE interest rates, money in an economy would become CHEAPER. So people will demand MORE money and thus MORE goods and services, which will increase prices of goods and services i.e. increase inflation.

This cycle goes:

Decrease Interest Rate – Higher demand of money-Higher demand of goods and services- Higher prices of goods and services- Higher inflation

Again lower interest rates would make the investment go out of the economy in the form of capital outflows. And again, a central bank would reduce interest rates when the economy is in the state of deflation or lower activity in the economy. I hope it clears the concepts. Any doubts, shoot a question.

Fed Cut and its impact

Now that we have understood what interest rates are and why do central banks reduce or increase them, we come to your specific question of Fed cuts and its implication on us.

Well, Fed is the central bank of United States (short form of Federal Reserve). A fed cut would mean that the Federal Reserve has cut the interest rate.

Now why has fed done so? This is because the US economy is in a state of slowdown. Prices are falling, so is dollar and the consumption demand in the economy is falling. To mend this situation, the Federal Reserve has taken this step to reduce the interest rate. This is expected to increase the demand for money and increase the demand for consumption of goods and services and help the economy fight recession/slowdown.

As far as impact on us in concerned, I would bring in the discussion of capital flows that we touched upon earlier.

Now in the global economy, there are investors who have money with them and they are looking at investment options all around the world. So they invest where they see higher returns. Now picture this:

In the US, interest rates are lower. In India, interest rates are higher. As an investor, if you have two options- in the U.S you investment fetches you 4% and in India, you get 9%. Where would you invest? Yes, of course –India

So what is happening is that a lot of dollar is flowing into India – which is doing two things – Raising the value of the rupee in dollar terms and of course our stock market indexes are rising.

So that, in a nutshell, is the impact on us. But in the long term, the impact on India will depend upon RBI’s response. The RBI has to keep its own things in mind- like Inflation. If it keeps the rate intact, capital inflows will increase because the rates in the US are falling.

And of course, capital inflows have their own impact on exchange rate and inflation etc.

We hope this makes it a bit clearer.

 

Generic terms

HACKER: a person who engages in illegal computer trespassing remotely via a communications network (e.g., the Internet).

Illegal hacking can be thought as breaking and entering into someone’s home without their permission. Every time one hears about a “cyber crime”, chances are that a hacker was involved. However, it must be stressed that contrary to popular belief, not all hackers are people who work outside the law. “Ethical hackers” are people who are engaged in fixing security issues on networks or debugging. Many are computer hobbyists that design software and programs purely for a harmless sense of fun. These hackers frequently use their real names and don’t attempt to hide their identity as they are not engaged in anything illegal.

AI: (Artificial Intelligence) the science and engineering of making intelligent machines that can mimic human thinking.

“Artificial Intelligence” was first used as a term by American computer scientist John McCarthy, who defined it as “the science and engineering of making intelligent machines”. The ultimate goal of AI then, is to design an intelligent machine that is capable of reasoning, planning, communicating, gaining knowledge, perception and object manipulation etc. In all respects, this machine would be able to mimic, if not surpass, human thinking. The science of AI uses tools from many fields of study including (but not limited to): psychology, computer science, robotics, economics, operations research, linguistics, neuroscience, philosophy, speech and facial recognition, logic etc. The first memorable show of AI versus human intelligence was demonstrated in 1997 when the then reigning chess champion Garry Kasparov was bested by the IBM manufactured machine named “Deep Blue”. Although strictly speaking, Deep Blue was not truly an “intelligent machine”, it did demonstrate the impact of the science. It is not uncommon to find many home appliances today touting some form of AI, but it is important to realize that this is using the term very lightly. For the moment, a totally intelligent and “self aware” machine exists only in the realm of fiction even if practical applications of AI surround us in real life.

 

Download problems with the 2nd edition of Oracle.

We have received some feedback on how the latest issue of Oracle (posted on 30th Jan 08) is not downloading properly. This problem has now been addressed. Any inconvenience caused is of course, deeply regretted.

PS: If left clicking on the links doesn’t seem to do anything, try right clicking on them and choose the “save link as” option to store it on any location on your drive.

 

Doubts on Economy

We understand that a lot of students, especially from science background face a great difficulty in understanding news/issues of economy. The most common complaint we have come across is that terms used in the news/articles are difficult to understand and so is the implication of a certain event.

So we have decided to come up with a new feature where we will answer questions on economy posted by students on this blog in the simple, layman terms and helps students appreciate a news/issue better and gain better understanding of the same.

So let your questions flow in.

 

“Oracle” January 20-26

Hello Students,

After an encouraging response from the students, the second issue of the “Oracle” for the week of January 20-26 is out. Its being uploaded here for your viewing.

Please note that free copies will be available only for the next two issues so students wishing to subscribe may contact us.

Cheers,

Team IAS Mentors

oracle-cover.pdf

p-2.pdf

p-3.pdf

 

EOUs

Export Oriented Unit means a unit, which exports more than 50% of its production.

Background:

• The Government amended in November 1983 a concession scheme to facilitate the setting up of export-oriented units (EOUs) in order to enable them to meet requirements of foreign demand in terms of pricing, quality, precision etc.

• EOUs can be set up anywhere in the country and may be engaged in the manufacture and production of software, floriculture, horticulture, agriculture, aquaculture, animal husbandry, pisciculture, poultry and sericulture or other similar activities.

• A 100 per cent export-oriented unit is an industrial unit offering for export its entire production, excluding the permitted levels of domestic tariff area sales. EOUs may be set up with a foreign equity participation of up to 100 per cent.

Benefits offered to 100% EOUs

The main advantages in setting up a unit as an 100% export oriented unit are

• Full duty exemption on all imports;
• Tax holiday for any 5 consecutive years within 8 years from the commencement of production;
• Full exemption from sales tax and excise duty on all local purchases;
• Permission to convert all foreign exchange earnings at market determined rate; and
• Permission to have upto 100% foreign equity;
• EOUs/EPZ units can raise foreign currency loans, subject to certain conditions;
• Industrial plots and standard design factories are available to EOUs/EPZ units at concessional rates