Dr.Raghuram Rajan, RBI Director
Dr.Raghuram Rajan, RBI DirectorReuters

The Reserve Bank of India (RBI) has cut the repo rate to 6.50 percent at its bi-monthly monetary policy review Tuesday. This is the first rate cut by the apex bank since September 2015. 

At 6.50 percent, the repo rate stands the lowest in the last five years. Repo rate is the rate at which the central bank lends money to commercial banks to maintain adequate liquidity in the economy.

A tight liquidity condition had persisted for a while now, some estimates indicating liquidity deficit worsening from Rs. 1.69 trillion as on 28 Jan. to Rs. 2.8 trillion as on 2 April 2016.

Economists had said that India's aspiration to grow at 8 percent of its gross domestic product (GDP) for the years to come may need some matching monetary decision alongside a consolidated fiscal path the budget 2016 had taken. 

Despite a consolidate125 basis points cut past year, commercial banks have not passed on the benefits to consumer/customers. This was due to the government inaction on the fiscal front that weren't exactly friendly to monetary easing, and hence had created a tight liquidity in the financial system.

The Budget 2016 has been widely appreciated as it is said to have ironed out such pain points in the financial system. The government's pledge to maintain a fiscal deficit target of 3.5 percent of gross domestic product for the coming year has been timely. Similarly the government's recent course correction by cutting retail rates on its small savings schemes has also helped effective monetary transmission.

"RBI was expected to take cognizance of sustaining weakness in industrial production and moderation in price inflation," said Anuradha Basurmati, associate director, India Ratings and Research, in a statement.

Basurmati added that rate reduction by the RBI will also be a test for the new method of calculating base rates. In order to quicken the pace policy transmission, a new method of calculating marginal cost of funds based on lending rate from April 1, 2016 had been introduced.

"The reduction in small savings rates announced in March 2016, the substantial refinements in the liquidity management framework announced in this policy review and the introduction of the marginal cost of funds based lending rate (MCLR) should improve transmission and magnify the effects of the current policy rate cut," said Raghuram Rajan, Governor of the RBI at the review meeting.

The RBI has also raised the reverse repo by 25 basis points to 6.0 percent.  Reverse repo is the rate at which the RBI borrows money from commercial banks. This move is expected to ensure more availability of cash in the banking system.

The central bank, indicating more room for rate cuts in the future, added that it will be accommodative in its policy stance going forward. However, the decision is subject to contingencies such as the monsoonal rains and other global economic factors. 

Medium Term

Apart from the above short term change, the RBI focusing on the medium term has also ensured availability of cash in the system by reducing the Statutory Liquidity Ratio (SLR), which is the reserve requirement commercial banks in India need to maintain in the form of gold, government bonds or any other asset.

SLR has been "reduced by 25 bps from 21.50 percent to 21.25 percent of the commercial banks' net demand and time liabilities (NDTL)", said the statement.

Much demanded request by commercial banks to cut the Cash Reserve Ratio (CRR), however, remained unchanged. CRR is cash deposits which banks need to keep with the RBI with no interest being earned.