This one little phrase is enough to send investors and financial experts into a frenzy. When the Reserve Bank of India cuts its policy rates, it is aiming to boost growth in the economy by reducing the rates on borrowing and lending of money. It is being speculated that the RBI will announce its next Rate Cut in the first week of April. But SwitchMe has a different prediction.
We think RBI won’t cut policy rates.
Let me explain why. In 2015, Reserve Bank of India cut the Policy Rates by a total of 125 basis points (1 Basis Point = 0.01%) and the Repo Rate (Repurchase rate) went down from 8% to 6.75%. At this time, they asked the banks to take the opportunity and reduce the interest rate offered to their customers. Loan borrowers started celebrating at the news but were quickly disappointed when they found that banks had only reduced interest rates by 60-70 basis points (0.6%-0.7%). “This is only half of the 125 basis points rate cut”, they protested. The justification that banks gave for this gap, was that the Repo Rate only affects the Base Rate calculations by a small amount. There are bigger factors than Repo Rate that affect the Base Rate. This is why the Interest Rate would not get reduced to the extent that the RBI wanted.
Base Rate Definition in India
Let me quickly explain:
Interest Rate is calculated according to Base Rate
RBI decides the formula for calculating Base Rate
According to this, Banks calculate their own Base Rate. This Base Rate is same for all loans offered by that Bank.
A ‘Spread’ is added on top of Base Rate to calculate Interest Rate of a loan. Spread is decided by the bank.
Interest Rate = Base Rate + Spread
With me so far? Good!
As I said, the Base Rate formula is decided by the RBI. It is a complex formula and can scare away even the bravest of men. So I’ll just give you the gist of the calculation. The Base Rate is calculated based on 4 factors. The Repo Rate has a small impact on one of these 4. So while the Repo Rate cut makes it cheaper for banks to get their funds, it does not drastically reduce the Base Rate and therefore, Interest Rate. Thus, the banks said that they could not cut their rates more than they already had.
It was in this moment, when all hope had faded, that Raghuram Rajan, Governor of the RBI said to the banks, “From 1st April 2016, you will calculate the Interest Rate using MCLR“. MCLR or Marginal Cost of Funds based Lending Rate, takes Repo Rate more strongly into consideration while calculating the Interest Rate. So with the MCLR, banks could cut their interest rates.
This was great news! The Interest Rates were sure to reduce from April 1st.
The reluctant banks then highlighted a separate issue. This issue is one of the ‘Small Savings Schemes’ (SSS) which allow people to deposit money and receive interest at a rate decided by the government. These savings schemes have troubled the banks for a long time because they offered high interest rates on deposits. The banks complained to the RBI that if they reduced the interest rate on their loans, they would also have to reduce the interest rate on Deposits to maintain their profits. If they reduced the Deposit interest rates, the rates would fall far below the SSS. People would prefer to put their money in the SSS over bank deposits like Fixed Deposits and banks would suffer losses. So they could not reduce the interest rates. Both sides found themselves in a stalemate and this was a problem that even RBI couldn’t solve as it was in the hands of the Government.
Plot Twist 2 – Enter Mr. Arun Jaitley
14 days before the MCLR was to be implemented, Finance Minister Arun Jaitley decided to take a bold step. On 18th March 2016, the FM agreed to reduce the interest rates on the Small Savings Schemes to make way for the reduction in the interest rates by banks. Different Small Savings Schemes suffered by different amounts as their interest rates were reduced ranging from 60-130 basis points (0.6%-1.3%). This was a substantial cut! Through this decision, the government has taken away the last excuse that banks had for not reducing their interest rates. The double-punch combo of MCLR + SSS rate cut, will force banks to finally give in to the demands of the RBI and slash interest rates.
With these developments taking effect, the question we are all left pondering is, “Is there any reason for the RBI to cut rates yet again?”. After a long and uphill battle, the RBI has finally moved all the pieces into position. Once the FD interest rates are cut by the bank, they will be able to get their funds at a lower cost and this automatically reduces the MCLR. Due to this, the rates are anyway expected to go down from April 1st and the RBI may decide to just wait for a while before the next rate cut.
What does this mean for you? Is it good news or not?
From a loan point of view, you needn’t be too disappointed about the fact that there will not be a further rate cut. With SSS rates reduced and MCLR to be executed soon, you are set to reap the benefits as the interest rate on your loans will decrease. New loan borrowers who take a loan after 1st April will be automatically put on MCLR while old loan borrowers will be continued on the Base Rate and will need to communicate to the bank that they want to shift from Base Rate system to MCLR. This is also a good time to consider switching your loan to a bank with the lowest Interest Rate. Use our Balance Transfer Calculator to calculate your potential savings through switching.
As someone who has invested their money by depositing it in a bank, you will feel the pinch as your money will now grow at a slower rate. But, you can still take comfort in the fact that without an additional RBI Rate Cut, the deposit interest rates are unlikely to go down even more than they are going to. So for you, the absence of the Rate Cut is probably good news.
Finally, let’s zoom out and take a look at the bigger picture. As citizens, we can draw comfort from the fact that India as an economy is steering towards greater efficiency. The measures taken by the Government and RBI might be painful for some people in the short term but they are aimed at benefiting the larger population in the long term.
And if you think about it, isn’t that ultimately what we all want?
SwitchMe is a registered trademark of SwitchMe Technologies Private Limited. SwitchMe does not claim the right to use any logo/ trademark other than its own. SwitchMe does not represent any other company, bank, or organization in relation to its services.