Explanation: What is Reverse Repo Normalization?
In one recent report, The State Bank of India, which is the country’s largest public sector bank, said: “…we believe the stage is set for a normalization of reverse repos.
To understand what reverse repo normalization is, it is important to understand what reverse repo is and why it is not “normal” today. It is also important to understand why the SBI talks about the reverse repo rate and not the reverse repo rate, which is often considered the benchmark interest rate in India.
What is monetary policy normalization?
India’s central bank, the Reserve Bank of India, continues to adjust the total amount of money in the economy to ensure smooth functioning. So, when the RBI wants to revive economic activity, it adopts a so-called “accommodative monetary policy”. Such a policy has two components.
First, the RBI injects more money (liquidity) into the economy. To do this, it buys government bonds on the market. As the RBI buys these bonds, it reimburses the bondholders, thereby injecting more money into the economy.
Second, the RBI is also lowering the interest rate it charges banks when it lends them money; this rate is called the repo rate. By lowering the interest rate at which it lends money to commercial banks, the RBI hopes that commercial banks (and the rest of the banking system), in turn, will feel an incentive to lower interest rates. . Lower interest rates and more liquidity, together, should boost both consumption and production in the economy. For a consumer, he would now pay less to keep money in the bank – so this incentivizes current consumption. For businesses and entrepreneurs, it would make more sense to borrow money to start a new business because interest rates are lower.
The converse of loose monetary policy is “tight monetary policy” and involves the RBI raising interest rates and sucking cash out of the economy by selling bonds (and taking money out of the system) .
When a central bank finds that accommodative monetary policy has started to become counterproductive (for example, when it leads to a higher rate of inflation), the central bank “normalizes policy” by tightening the stance monetary policy.
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What is reverse repo and how does it fit into policy standardization?
Reverse Repo is the rate of interest commercial banks pay to the RBI when they place their excess “liquidity” (money) with the RBI. The reverse repo is therefore the exact opposite of the repo rate.
Under normal circumstances, i.e. when the economy is growing at a healthy pace, the repo rate becomes the benchmark interest rate in the economy. This is because it is the lowest interest rate at which funds can be borrowed. As such, the repo rate is the floor interest rate for all other interest rates in the economy – whether it’s the rate you pay for a car loan or a home loan or the interest what you earn on your fixed deposit, etc.
But imagine a scenario where the RBI injects more and more liquidity into the market but there are no new loan takers – either because the banks are unwilling to lend or because there are no real demand for new loans in the economy. In such a scenario, the stock moves from the repo rate to the reverse repo rate because the banks are no longer interested in borrowing money from the RBI. Rather, they are more interested in parking their excess cash with the RBI. And this is how the repo becomes the real benchmark interest rate in the economy.
Like this early 2020 story explained, the reverse repo had become the benchmark rate in India since the start of the Covid pandemic. In short, the RBI had widened the spread between the repo rate and the reverse repo rate (SEE CHART) to make it less attractive for banks to simply park their funds at the RBI. A lower repo rate pushed banks to make more new loans into the economy.
What does reverse deposit normalization mean?
Simply put, this means reverse repo rates will go up.
Over the past few months, in the face of rising inflation, several central banks around the world have either raised interest rates or signaled that they will soon.
In India too, the RBI is expected to increase the repo rate. But before that, the RBI is expected to increase the reverse repo rate and narrow the gap between the two rates. Immediately after Covid, RBI had widened this gap (See GRAPH).
The SBI initially expects the reverse repo to rise from 3.35% to 3.75% while the repo rate remains at 4%. This will incentivize commercial banks to hoard excess funds with RBI, thereby sucking some of the liquidity out of the system.
The next step would be to increase the repo rate.
This normalization process, which aims to curb inflation, will not only reduce excess liquidity, but will also lead to higher interest rates across the Indian economy, reducing consumer demand for money. (since it would make more sense to just keep the money in the bank) and make it more expensive for businesses to take out new loans.