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Repo rate: To cut or not to cut

by Tavaga Invest
REPO Rates

A vital tool in monetary policy, the current scenario has revealed the repo’s limitations

By: Tavaga Research

The year 2019 saw RBI cut the repo rate five times in a row, among the highest in a calendar year. With consumer demand refusing to pick up, RBI tweaked the repo in five of the total six meetings (bi-monthly) for monetary policy in a year. 

What is Repo Rate? 

The repo rate is one of the key tools for RBI to regulate the liquidity of banks with. Technically, the repo (short for repurchasing option) is used by RBI to control the money supply in the financial system.

RBI, like all other central banks, lends money to commercial banks for the short term in the country at the repo rate, meaning it is the rate of interest at which other banks borrow from RBI.

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When there is a need for more liquidity in the economy (deflation), RBI reduces the lending rate to banks, signaling to banks to do the same with their customer lending rates. Lower interest rates on loans encourage people to borrow from banks in case of a fund crunch. 

Repo rate
Source: Tavaga

If on the contrary, the economy heats up with inflation, RBI raises the repo rate, signaling banks to tighten their purse-strings that ripples through the economy and makes borrowing for people harder, reining in the excess liquidity in the economy.

The higher the policy rate, the higher the cost of credit, which lowers the demand for credit, resulting in less supply of money in the economy. A cut in the rate results in increasing the supply of money.

However, as the central bank RBI does not have the ability to take measures that directly reach the masses. With repo rate, RBI expects commercial banks to follow suit but the outcome is not always guaranteed. Even if banks don’t offer the exact decrease in interest rate, they are expected to offer a partial decrease in interest rates for customer borrowings/credit.

What is the repo rate in India?

The present-day is a case in point. RBI has cut the repo in all but one of its bi-monthly monetary-policy-committee meetings in 2019, no less than a cumulative reduction of 135 basis points. The repo rate, 2019, came down to 5.15 percent and it is also the current repo rate. 

Why are bank rates still high?

Despite the repo rate cuts, banks’ average lending rate is 10.36 percent, going down by only 3-4 basis points on average in 2019.

Asia’s third-largest economy is seeing a credit crunch that has not been witnessed in recent history. But banks are in a bind as well. The shadow banks or the NBFCs (non-banking financial companies) ran into a crisis shredding their credit-worthiness, putting conventional banks under pressure for their exposure to NBFCs. 

Simultaneously, the trend of bad loans and cooked-books to downplay their role continued to dog banks with new revelations, such as that of PMC bank, throughout 2019. The twin dilemma resulted in banks coughing up a higher risk premium for their insurance. And, putting off passing the rate cuts to us.

In the chart below, we see that even as the repo rate has steadily gone south since the start of 2019, the difference between the bank rate and the repo rate (spread) has only increased.


Source: Tavaga research, RBI 

Rate cut’s disadvantage

Even if we look away from the macro-economic impact of a repo rate cut during deflation, it may have meaning for us at the level of our personal investments and savings. 

A repo rate cut, if passed on to us, would mean cheaper loans. But for those of us wary of debt, and looking to fund our money goals with our investments, it could be the trigger to make some changes. 

If loan interests go down, then the reverse trend also affects us. The interest we earn from banks on our deposits, be they savings accounts, fixed, or recurring, goes down too. It then makes sense for us to move some of our corpus from such deposits into other means of investment that earn better returns and are not directly ruled by bank rate changes.

Rate cuts move the markets

The stock markets and money markets react sharply to repo rate changes, as these have a direct impact on the economy’s liquidity and hence, earning capacity in the markets. 

The monetary policy committee’s bi-monthly meetings often see markets move before (in speculation) and after (in reaction) to changes in the repo rate.

The urgent case for consecutive cuts

Consumer demand or consumption contributes to two-thirds of our country’s GDP, which has taken a hit in the last couple of years. RBI’s repo rate cuts, under its new governor appointed in 2019, was to arrest the slump.

Repo put to good use historically

RBI had cut the repo by 200 basis points between January 2015 and April 2016, a 15-month period. The moves paid off as the GDP grew from 7.1 percent in the last quarter of fiscal 2015 to 9.3 percent in Q4 of fiscal 2016.

The Catch-22 in repo cuts

Tweaking monetary policy could also be counter-productive now, as inflation is shooting up even as consumption is at an all-time low. We are witnessing what some experts are calling stagflation.

Retail inflation at a five-year high of 7.35 percent, driven mainly by food prices, there is almost no room to axe the repo rate in order to encourage credit. The most likely answer to increasing government spending instead, too, could be fraught with risk as there has been a shortfall in revenue collection by the government this fiscal.

The working behind the repo rate

Central banks like RBI don’t lend and borrow like commercial banks. Hence, the way the repo rate is applied is different from say, a home loan interest rate. Banks go to the central bank for their loans which are called secured loans. 

For such a loan, RBI buys government bonds from the banks at a percentage of discount, which equals the repo rate, with an agreement to sell them back to the bank at their par value (the full price of the securities) after a given period. The move is called a repurchase agreement. The maturity of such agreements ranges from overnight to two weeks. The difference in the purchase and resale rates is what RBI earns as interest. 

The repo agreements are done to increase the supply of money in the economy. The process is reversed when RBI wants to contract the money supply (banks purchase government securities from RBI) and borrows at the reverse repo rate.

Effect on bank base rate

Usually, with the announcement of a repo rate increase, banks increase their base rates and vice versa. 

A bank’s base rate is the interest rate for reference and is the minimum percentage rate at which banks may lend. 

In practice, banks add risk premiums and maturity premiums on the base rate to compensate for the credit risk in lending to the borrower.

For example, large corporate clients may have to pay the base rate and a 2 percent premium on their loan, while a smaller corporate borrower may have to shell out a 5 percent premium on the base rate (as the risk of repayment default is higher for a smaller entity).

Other key rates we should know

The reverse repo rate is one at which RBI borrows from the commercial banks (as explained earlier). 

MCLR and the base rate are both the minimum rates at which banks can lend. The difference lies in the method of calculation of both the rates, MCLR being improvisation on the base rate, and takes into consideration the relative riskiness of individual customers to arrive at a final lending rate.

Other tools with RBI

Of course, the repo rate is not the only way for RBI to modulate the supply of money. Central banks have the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR) as well, both of which are reserve requirements of commercial banks.

The CRR stipulates the percentage of the total deposits of a bank that has to be kept in a current account with RBI. 

The SLR dictates the number of deposits available to a bank that has to be invested in government or other securities as specified by RBI.

Increasing the CRR and SLR would contract the money supply and vice versa.


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