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How FM intends to make loans cheaper, spur economic activity?

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New Delhi, Aug 23: Among slew of measures to boost the economy, Finance Minister Nirmala Sitharaman today said the banks would pass on any change in the benchmark monetary policy rate to borrowers without any delay, and she also announced capital infusion of Rs 70,000 crore into public sector banks to boost lending.

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These two measures are expected to spur economic activity. Loans/credit are very important component of a business cycle. For start-ups, getting loans at lower rates are of utmost importance. In case of a newly setup company, loan provides for operating costs till the company breaks-even and starts making profit.

Even in case of established companies, actual money comes back only when sale happens in the market, but till then, production costs would have be covered either by credits or by the portion of working capital that is re-invested. If loans are available for cheap, then business would like to operate on borrowed money than re-infusing part of their profits into operations. FM's announced to pass on rate cuts and capital infusion, will, firstly, make loans cheaper, seondly, willl increase availability of loans.

[From housing to auto sector, Sitharaman announces slew of measures to boost economy]

Explained: How will these two measures spur economic activity?

Once in every two months, the Reserve Bank of India (RBI) makes a Monetary Policy announcement in which the central bank announces, among many other things, the changes in Repo Rate and Reverse Repo Rate. Repo Rate is the rate of interest at which the RBI lends money to banks.

Simply put, the government would want to lower the Repo Rate when it wants to boost the economic activity. It is a way to infuse money or cash (liquidity) in the economy when there are signs of slow down. If Repo Rate comes down, then it would cost banks less to borrow from the RBI. This in turn allows the banks to lend in the market at lower price without having to compromise with its own profit margin.

[Sitharaman's action plan for auto-sector: These measure announced to boost vehicle sales]

Once the lending rate of banks come down, the businesses would hesitate less to borrow and invest. Afterall, a business, of any kind, is about earning more money than what has been spent. A large part of what has been spent or investment would be in the form of borrowings from the bank.

So, what a business or company earns should not only cover its costs on wages to the employees, raw material, process involved in getting a product or service ready for market, but also the interest it pays on the money borrowed from banks.

Essentially, when the lending rates come down, more businesses would want to borrow and invest in expansion of business which in turn boosts the economic activity. This is the concept behind lending rates, repo rates and their relation with the economic activity on the ground. In reality, many other factors play a role in determining the level of economic activity.

Why it had to be done?

Till now, banks generally lagged in transmitting RBI's reduction in repo rates to borrowers. The RBI has this year cut interest rates by 110 basis points in four installments but banks have passed only a part of it to borrowers. Before the last reduction earlier this month of 35 basis points, the bank on an average had passed only 29 basis points out of 75 basis points cut affected during 2019.

The finance minister also announced upfront capital infusion of Rs 70,000 crore into public sector banks to boost lending and improving liquidity situation. The fund infusion is expected to generate an additional lending and liquidity in the financial system to the tune of Rs 5 lakh crore.

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