The Reserve Bank of India’s (RBI) bi-monthly economic policy meet, currently underway, is likely to maintain a status quo on all key interest rates, believe experts. There are market expectations that RBI’s monetary policy committee (MPC) may change the policy stance from ‘accommodative’ to ‘neutral’.
Although falling outside the domain of policy committee, the central bank is likely to increase the reverse repo rate by 15 to 25 basis points. A research report from Bank of Baroda (BoB) says the RBI will take steps to address the excess money in the system by raising the reverse repo rate by 25 basis points.
The RBI is expected to raise the reverse repo in the backdrop of rising inflation. The domestic inflation was 5.59 percent in December, highest in five months. At the same time, Brent oil prices are on a boil as they hover around $93 per barrel.
What is reverse repo?
Reverse repo rate is the interest paid by RBI to banks when they park their surplus funds with the RBI. Currently, it stands at 3.35 per cent. When the central bank raises reverse repo rate, it gives an incentive to the banks for parking funds with it instead of using it for commercial lending.
However, its impact on interest rates is likely to be muted. Usually, repo rate directly impacts the cost of borrowing by retail borrowers. The repo rate is the rate at which the RBI lends to commercial banks.
When there is an excess liquidity in the system, RBI tends to raise the repo rate to suck out liquidity. To mop up extra liquidity, RBI borrows extra money from banks, on which it offers an interest. Since banks start earning interest on these deposits, they lend the money to the central bank, which is certainly a safe and reliable way to earn interest.
Impact of tinkering with reverse repo
When reverse repo rate increases, liquidity in the system declines. Because of lack of liquidity, there is less money available for lending, which helps in bringing the inflation down.
On the other hand, RBI slashes reverse repo rate to inject liquidity in the system. When reverse repo rates start to touch the gravity, banks stand to earn a lower interest on their loans to central banks. This gives them less incentive to park their surplus funds with the regulator.
As a result, they would prefer to lend the surplus money to retail borrowers and earn a higher interest instead of parking it with the RBI. This would push the inflation higher.
Since reverse repo rate is a potent tool to battle inflation in RBI's armory, they can have a muted impact on the rate of interest too. It would not be an exaggeration to say that whenever there is a change in the reverse repo rate, there is a domino effect in the economy.
Following are the repo and reverse rep rates for past two years:
|Reverse repo rate
However, the impact of tinkering with reverse repo is not as direct and immediate on retail lending rates as in the case of repo rate hike where the cost of borrowing rises for banks, which, in turn, pushes the cost for retail borrowers.
State Bank of India (SBI) Research Report stated that the RBI is likely to increase the reverse repo rate by 20 bps outside MPC. The report — written by Dr Soumya Kanti Ghosh, Group Chief Economic Adviser, State Bank of India — states: “The time is now appropriate to go for a 20-basis point hike on reverse repo rate, but outside the MPC meeting as enshrined in the RBI act that clearly lays down that reverse repo is more of liquidity management. A hike in the reverse repo is also required as a larger corridor has resulted in rate volatility.”