While reading the newspapers recently, you must have come across plenty of reports about the Reserve Bank of India's [Get Quote] credit policy for the year. Many of you must have wondered: what is this credit policy? Why is it important to us?

Every year around April, the RBI announces its Annual Policy Statement, usually called the Monetary Policy or the Credit Policy.

This statement outlines the RBI's assessment of the economy and whether it is on the right rack of sustainable growth without succumbing to inflation.

To understand that, a few words about monetary policy.

Monetary policy

Essentially, the RBI regulates the money supply in the country. It has to decide when to increase money supply and when to reduce it.

When the economy is in the doldrums, the RBI relaxes the monetary policy. This means it reduces interest rates which, in turn, lowers borrowing costs (because interest rates fall). This encourages consumers to borrow more and spend more. Companies too are able to borrow at lower rates of interest and this encourages them to grow and increase their operations.

At the other end of the business cycle, when the economy is getting overheated, the RBI steps on the brakes, contracting money supply. This time, it raises interest rates. Once the cost of borrowing costs rises, it slows down the economy because the reverse of the above happens.

RBI and interest rates

The RBI impacts interest rates by tinkering with the Reverse Repo Rate and Repo Rate.

The Reverse Repo Rate is the rate at which the RBI will borrow very short-term funds from banks. Currently this is at 5.5%.

The Repo Rate is the rate at which it lends short-term money to banks. This is currently at 6.5%.

The repo and reverse repo rates are the base rates for borrowing and lending in the economy. If these rates are raised, all other rates tend to go up in tandem.

The logic is pretty simple. If the RBI raises the Repo Rate, the banks will have to shell out more to borrow from the RBI, which increases their cost. This is a signal that they would do well to raise their interest rates on loans to the public as well.

How is the common man affected?

Well, if prices rise, he is obviously affected.

If interest rates rise, then his borrowing costs (loans) increase.

On the other hand, he will be able to get a higher interest rate on his savings.

• Why a home loan makes sense

What has been affected?

Which bring us to, what did the RBI do in its policy statement for 2006-'07?

It left the rates unchanged. This means the RBI feels that, although growth is strong, it's not inflationary, ie prices are well under control. So there's no need to raise rates.

At the same time, the RBI is worried that banks may have lent too much to certain sectors of the economy, especially real estate. It's worried about the high real estate prices and feels that banks should slow down lending to the sector and help curb demand.

That's why it has increased the risk weights for real estate loans to 150%. What does that mean?

According to regulations, banks are supposed to keep aside Rs 9 as capital for every Rs 100 worth of loans. According to calculations this means that the loans carry a risk weight of 100. If the risk weight for a category of loans is increased to 150, then banks will have to keep aside Rs 13.50 for every Rs 100 worth of loan sanctioned to that category.

Since banks have to set aside more capital, their cost of capital increases and they will therefore raise the interest rates on loans to real estate contractors.

Note that this increase is for loans to real estate contractors and not home loans.

The RBI has also increased the provisioning that banks will have to make for home loans above Rs 20 lakh (Rs 2 million), personal loans, loans for trading in the stock markets and loans for real estate. This is done as a prudent measure to set aside a sum to take care of future bad loans (should people start defaulting on loan payments). The effect here too will be to make these loans slightly more expensive.

In other words, loans to the real estate sector, high value housing loans, personal loans, etc, will become more expensive. But there's also plenty of competition among banks, so much depends on whether they pass on the increased costs to their customers.

The RBI has also said it will curb money supply growth this year. That could mean a tightening of policy rates mentioned above later on.

The RBI has also flagged certain areas of concern such as high oil prices. If these trends continue, interest rates are likely to rise.