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IAI Actuarial Core Principles · Business Economics · Impact of the macroeconomic environment on business

The Reserve Bank of India raises its policy repo rate and banks pass the increase on to borrowers. Which effect on a highly geared Indian real-estate developer funding projects with floating-rate loans is most likely?

A higher repo rate raises the developer's floating-rate interest cost and also makes home loans dearer, reducing buyer demand. Both effects squeeze profit and cash flow, and the pressure is greater for a firm with high gearing.

  1. ALower interest costs and higher profit, because the cost of borrowing falls
  2. BHigher interest costs and lower buyer demand for housing loans, squeezing profit and cash flowCorrect
  3. CNo effect, because interest rate changes only affect savers
  4. DHigher demand for flats, because buyers rush to borrow before rates rise further, with no cost effect on the developer
  5. A fall in the developer's debt servicing burden as inflation erodes the loan

Explanation

Floating-rate loans reprice upwards, raising the developer's interest cost. Higher mortgage rates also reduce affordability and demand for housing. Both effects squeeze profit and cash flow, particularly for a highly geared firm.

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