What is the Repo Rate and Why Does Everyone Care So Much About It?

What is a Repo? A ‘repo’ is nothing but a ‘repurchase agreement’. Even normal individuals can enter in a repo agreement. I give you a signed piece of paper in exchange for Rs. 10k. The paper states that “I will repurchase the signed piece of paper from you at a given date in the future for Rs. 11k.” The Rs. 1k or 10% is the ‘Repo Rate’. In the case of repo agreements between a central bank and commercial banks, the piece of paper is called the ‘Repo Rate Agreement’.

Why does the central bank do this? Because a central bank needs to control the ‘cash in the system’, so to say. That’s in their job description. In order to do that, they usually put up a handful of rules, the primary being the reserve requirements for banks and the ‘repo’ rates.

banks-cut-base-rate-as-rbi-lowers-repo-rate-by-25-bps-financial-chronicle-03-june-2015

What are the reserve requirements? In India, the RBI has told the banks that they need to have a CRR (Cash Reserve Ratio) of 4% and a SLR (Statutory Liquidity Ratio) of 21%. This simply means that for every Rs. 100 that a bank has in its hands, it needs to give for safe-keeping Rs. 4 in hot cash and Rs. 21 as mostly investment in government bonds to the RBI. This Rs. 25 acts as a guarantee of sorts in case the bank collapses.

Where does Repo figure in this? Let’s suppose that a bank has only received Rs. 100 worth of deposits. The bank gives the RBI Rs. 25 by way of maintaining the CRR and SLR. Slowly, the bank lends out the remaining Rs. 75 to its customers. Now, the banks figures out that there is still some demand for loans. It’s out of money though. So the bank tells the RBI “Hey, lend me Rs. 50. I’ll give you back Rs. 12.5 by way of CRR and SLR. Let me utilize the remaining Rs. 37.50 for my business.” Remember, the RBI prints money. The RBI can never run out of money to lend, unlike the banks. The RBI replies “Fine, take this Rs. 50. But for your SLR requirements, you will have to purchase government bonds from me. So, at a given date in the future, you will repurchase your agreement from me at Rs. 50 plus 6.50% interest per annum and I will repurchase my government bonds from you at 6.00% per annum.” The first part of the agreement, where the bank repurchases its agreement from the RBI is called the Repo Agreement. The second part of the agreement, where the RBI repurchases its government bonds from the bank is called the Reverse Repo Agreement. You might have noticed that the Reverse Repo Rate is always lesser than the Repo Rate. That’s one of the perks of being the controller of the banking system of the country.

The central bank and the commercial banks engage in these repo transactions (Called ‘Repo Rate Auctions’) very often. The repo is basically how money flows from the central bank to the banks and into the system.

Why does the Repo Rate matter so much? So, we’ve seen how a repo works, both generally and in the banking system. But why does the 6.50% matter so much? Every two months, the RBI does a policy review. The most important part of it is the modification of ‘key rates’ (Repo, CRR, SLR, MSF), if any.

Indian banks are currently ‘borrowing’ from the RBI at 6.50%. Imagine that the RBI announces a 50 Basis Points ‘rate cut’. The 6.50% drops to 6.00%. The banks can now borrow more and pay lesser interest to the RBI. Higher cash in the hands of the bank will mean higher lending from the banks to the public. Higher cash in the hands of the public means more spending on goods and services. More spending and demand leads to inflation – or rise in prices of goods and services. The public starts suffering from inflation.

The RBI now intervenes and increases the Repo Rate, to say 7.25%. Now, the banks can borrow only lesser and pay a higher interest rate on it as well. You can probably fill in the gaps of what will happen next based on what we saw above. This gradually leads to a recession. The RBI again intervenes and ‘cuts’ the rate, again. It’s a vicious cycle and a cycle which needs to be monitored closely. Ineffective monetary policy will lead to depression, hyper-inflation and all sorts of economic anomalies. Although the Repo Rate is not the only weapon at the disposal of a central bank, it’s the quickest and deadliest.

Alice Rivlin, the former Vice-Chair of the U.S. Federal Reserve puts it in a nutshell: “The job of the Central Bank is to worry.

P. S. Incidentally, ‘Bps’ or ‘Basis Points’ refers to decimal places. 10 Basis Points is equal to 0.10%, 25 Basis Points is equal to 0.25% and so on.

This article was written by Dinesh Sairam (PGDM, Batch 21, XIME-B)

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A Layman’s View of the Goods and Services Tax

GST
(Source: FosterGem)

 

The Goods and Services Tax (GST) is the biggest reform in India’s indirect tax structure since the economy began to expand 25 years ago. At long last, a dream is set to become reality. The 122nd Constitution Amendment Bill came in Rajya Sabha with a broad political consensus (And the “good wishes” of the Congress Party), which holds the crucial cards on its passage.

 

GST is a single indirect tax for the whole nation, which will make India a unified common market. GST is a single tax on the supply of goods and services, right from the manufacturer to the consumer. Credits of input taxes paid at each stage will be available in the subsequent stage of value addition, which makes GST essentially a tax only on value addition at each stage. The final consumer will thus bear only the GST charged by the last dealer in the supply chain, with set-off benefits at all the previous stages.

 

In other words, the prices that we pay for goods and services have the taxes embedded in them. Mostly, the consumers are not even aware of or they ignore the tax they pay for things they buy. This is because there are plethora of indirect taxes such as sales tax, excise and VAT, which leads to increased complexity. The GST seeks to untangle this knot and subsume all in one single tax, thereby making India an economically unified market.

 

The Empowered Committee of State Finance Ministers, which deliberated on the tax and its implications, has recommended what taxes are to be subsumed in the GST:

 

In the Central Taxes:

1) Central Excise Duty;

2) Additional Excise Duties;

3) The Excise Duty levied under the Medicinal and Toiletries Preparation Act Service Tax;

4) Additional Customs Duty, commonly known as Countervailing Duty (CVD);

5) Special Additional Duty of Customs – 4% (SAD);

6) Surcharges, and

7) Cesses.

 

Among the State Taxes and Levies:

1) VAT / Sales tax;

2) Entertainment tax (unless it is levied by the local bodies);

3) Luxury tax;

4) Taxes on lottery, betting and gambling;

5) State Cesses and Surcharges in so far as they relate to supply of goods and services; and

6) Entry tax not in lieu of Octroi.

 

For Example :

Assume that the cost of raw material is Rs. 100.00. The tax rate is assumed to be 10% for all taxes.

 

Under the CENVAT System:

On the Rs. 100.00 raw material, the manufacturer pay Rs. 10.00 as tax. The manufacturer adds Rs. 20.00 value. To this the manufacturer adds Rs.2.00, which is the CENVAT or Central Value Added Tax. In the example, the CENVAT is assumed at 10% of the Rs. 20.00 value added by the manufacturer. So the cost for the retailer is Rs.132.00 [Rs. 100.00 (Raw Material) + Rs. 10.00 (Tax on Raw Material) + Rs. 20.00 (Manufacturer Value Addition) + Rs. 2.00 (Tax on the Value Addition)]. When the retailer sells it to the consumer, he adds his own margin at Rs. 20.00. This takes the price to Rs. 152.00. Add 10% Sales Tax to this, which increases the price to Rs. 167.20. Thus the final price the consumer pays will be Rs. 167.20. Of this final amount, the taxes paid by the consumer is Rs. 27.20.

 

Under GST:

In GST, a Value Addition Taxation system is followed. This means each person pays tax only on the Value Added at that point. In our example, when the retailer sells the tax is applied only on the margin of Rs. 20.00 and not on the Rs. 132.00 which is the cost paid to the manufacturer. So the tax the consumer pays is considerably (~48%) lower at Rs. 14.00 [Rs. 10.00 (The tax paid by manufacturer when the raw material was bought) + Rs. 2.00 (The tax on the manufacturer’s Value Addition) + Rs. 2.00 (The tax paid on the margin of the retailer)]. The ultimate effect is the reduction of the end consumer’s (The common public’s) tax burden.

 

In other words, under the current CENVAT system, there is a cascading effect or double taxation i.e. the consumer pays tax on the tax already paid by the manufacturer. The GST circumvents this problem completely. Below is another example of a fully worked-out difference between the CENVAT system and the GST system.

 

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(Source: ICICI Bank Research)

 

Know your GST

 

The GST Council

The GST Council will consist of the union Finance Minister (chairman) and MoS in charge of Revenue; Minister in charge of Finance or Taxation, or any other Minister, nominated by each state. Decisions will be made by three-fourths majority of votes cast; Centre shall have a third of votes cast, states shall together have two-thirds mechanism for resolving disputes arising out of its recommendations may be decided by the Council itself.

 

 

The Levy of GST

Both Parliament, state Houses will have the power to make laws on the taxation of goods and services. Parliament’s law will not override a state law on GST exclusive power of The Centre to levy, collect GST in the course of interstate trade or commerce, or imports. This will be known as Integrated GST (IGST). Central Law will prescribe manner of sharing of IGST between Center and states, based on GST Council’s views.

 

What’s Out of GST?

Alcoholic liquor for human consumption, Petroleum crude, high speed diesel, motor spirit (petrol), natural gas and aviation turbine fuel (The GST Council will decide until when).

 

And What’s In?

Tobacco and tobacco products (The Centre may impose excise duty on tobacco).

 

What has happened so far?

Budget 2006-07: GST by April 1, 2010, announced. Subsequently, Empowered Committee (EC) of state Finance Ministers tasked with drawing up road map and design.

April 2008: EC, headed by the then West Bengal Finance Minister Asim Dasgupta, submits report to the central government, which offers its views and comments in October and December of that year. Joint working groups are then set up to examine options on exemptions and thresholds, taxation of services and inter-state supplies etc.,

November 2009: EC releases its First Discussion Paper.

March 22, 2011: The Constitution (115th Amendment) Bill is introduced in the Lok Sabha; is referred to Parliamentary Standing Committee on Finance, which submitted its report on August 7, 2013. Bill lapsed as term of the Lok Sabha ended in 2014.

December 19, 2014: Constitution (122nd Amendment) Bill introduced in Lok Sabha.

May 6, 2015: Constitution Amendment Bill passed by Lok Sabha.

May 12, 2015: Bill referred to a 21-member Select Committee of Rajya Sabha headed by Bhupender Yadav.

July 22, 2015: The Committee submits its report.

Monsoon and Winter Sessions 2015, Budget Session 2016: Bill not tabled in the face of opposition led by the Congress and persistence of sticking points.

 

What’s Ahead?

The President shall constitute the GST Council. The GST Council shall make recommendations on:

1) Taxes to be subsumed
2) Exemptions
3) Model GST laws, Principles of Levy, etc.
4) Threshold for exemption
5) Rates, including floor and bands
6) Special rate/rates for specified period
7) Date from which GST to be levied on crude, high speed diesel, natural gas, aviation turbine fuel and petrol
8) Special provisions for the Northeast, J&K, etc.

 

Parliament will pass a legislation on Central GST (CGST) and Integrated GST (IGST). All the 29 states and 9 UTs will be asked to pass their state GST (SGST) Acts. Dates of implementation of CGST, SGST and IGST have to be negotiated and synchronized.

 

Some States will initially act up. The GST will give them short term losses. For instance, the aggregate tax amount collected by the Tamilnadu and Maharashtra governments under the current CENVAT and State Taxes system is much higher than what they would get out of GST once it is implemented. This is owing to the fact that these states are net manufacturers of goods and services. The Centre has promised to compensate such states with a higher percentage of the net tax proceeds. Hopefully, that will calm them down. Gradually, they too will be brought under the broad umbrella of GST.

 

This article was written by Varnita Deep (PGDM, Batch 22, XIME-B)