Understanding the impact of RBI’s Repo and Reverse Repo Rate Cut

It has happened as expected. RBI has announced a 25 basis point cut in the Repo and Reverse Repo rates. For the less exposed, this means that the Repo Rate has fallen from 7.75% to 7.5% while Reverse Repo Rate has fallen from 6.75% to 6.5%. What does this mean to different people? The segments we cover in this article are Banks, Industry, ordinary people and the broader economy.

Impact on Banks

To understand the impact of a cut in Repo and Reverse Repo Rates on banks, it is important to understand the role they play in banking. Repo and Reverse Repo are basically instruments used by the RBI to influence the total monetary base of banks.

To get a grip on this, it is important to understand how banks work and what the term monetary base means. Banks engage in a practice called Fractional Reserve Banking (FRB). As explained in the linked article, under FRB, a bank lends many multiples of the actual cash in hand. This cash they have is what I mean by monetary base. Clearly, any addition to the monetary base adds to the bank’s ability to make loans by creating money from nothing (as explained in the linked article).

In India, banks’ monetary base takes 2 forms – CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio). CRR is the amount of actual cash that banks need to hold with the RBI. SLR refers to the amount (by value) of approved securities (government bonds, gold and approved, privately issued financial instruments) that banks are mandated to hold. Currently, CRR is 4% and SLR is 23%. Together, they constitute the monetary base of the Indian banking system.

However, what CRR and SLR do not cover is the extent to which the RBI can lend to banks. That is covered under the Repo and Reverse Repo. In a Repo or a repurchase agreement, the Repo seller (the bank) sells an approved security to the RBI with the understanding that at a certain date in the future, the bank will buy the security back from the RBI. The bank gets cash and the RBI the security.

One would expect that this would not influence the monetary base because while the bank gets cash and adds to its CRR base, it loses possession of the security and falls behind on its SLR base and can therefore not lend more. The interesting part is that this problem in the way of expanding bank lending is eliminated by the way the Repo system works.

Very interestingly, during the term of the Repo, the bank is allowed to count the security thus sold to the RBI as part of its investments to fulfil the SLR requirement. So, the net effect of a Repo transaction is an addition to the bank’s cash reserves without falling behind on SLR requirements. With this, the bank can now engage in much more lending.

At the end of the term of a Repo, the bank buys the security back from the RBI at a price higher than the original sale price. The difference expressed as a percentage of the original sale price is the Repo Rate. Thus, Repo Rate is used to calculate the price at which the security is bought back by the bank. It is the equivalent of an interest paid by the bank to RBI.

It might seem that at the time the bank buys the security back, its cash reserve falls. However, the bank can then enter into a fresh Repo transaction and sell the security back to the RBI, bringing the cash reserve back to the higher level. In this manner, Repo becomes a means for the RBI to maintain a steady level of lending to banks.

But all this additional lending would mean more purchases of securities to meet SLR requirements. This would mean the need to deploy cash for the same. That cash would go outside the system of lending and reduce the system’s lending potential. This problem is solved by what is called the Reverse Repo.

In a Reverse Repo, the RBI sells an approved security to the bank with the understanding that it will buy it back at a future date at a higher price. The difference between the 2 prices expressed as a percentage of the original selling price (per annum) is called the Reverse Repo Rate. The Reverse Repo Rate thus becomes the interest rate received by the bank for lending cash to the RBI.

The important point for us to note is that a bank may show securities bought from the RBI through the Reverse Repo window as part of its SLR commitments. Further, as in the case of the Repo, at the end of the term of the Reverse Repo, the bank can enter into a fresh Reverse Repo with the RBI.

Summarising the understanding

Bank XYZ hits its lending limit based on its CRR and SLR. It sees potential for more lending. It offers RBI a portion of the securities it holds as part of a Repo transaction and gets cash. It deploys 23% of this new cash to obtain securities under the Reverse Repo window from the RBI, thus keeping the cash within the system. The bank now gets to create new money amounting to 1/(CRR+SLR) times the money borrowed under the Repo window and lend it out at interest. The Repo window thus becomes a cheap source of borrowing for banks.

The impact of a cut in Repo and Reverse Repo Rates

A cut in Repo and Reverse Repo rates basically reduces the bank’s cost of borrowing from the RBI to add to its reserves. It enables banks to either increase the interest rate spread on loans made by the bank or offer borrowers lower rates of interest without eating into its own interest rate spread. Thus, a cut in Repo and Reverse Repo Rates increases the banking system’s potential by expanding more loans in a profitable manner.

Impact on Industry

With lower repo and reverse repo rates, industry gets to borrow more and even gets to pay lower interest rates on its borrowing. Therefore, those businesses that are in a position to secure additional lending from the banking system will benefit from lower repo and reverse repo rates.

Impact on ordinary people

The impact on ordinary people can be felt in 2 ways. In the nearer term, greater lending to businesses will lead to more business investment and employment opportunities. In the medium and longer term, however, the dominant factor influencing ordinary people will be the increased money supply (inflation), which will send prices of consumers’ goods soaring, resulting in future pressure to raise interest rates thus forcing the pricking of the inflationary bubble and the onset of the depression.

Impact on the broader economy

In the long-run, reducing Repo and Reverse Repo rates is harmful for the economy as it is just a means to lend reserves to banks, enabling them to engage in far bigger inflation to undertake much more credit expansion through FRB. While this lending will have some short-term positive effects, in the long-run, it creates and worsens the inflationary boom of the familiar boom-bust cycle. It also sets the conditions for the inevitable raising of interest rates thus pricking the inflationary bubble and triggering the depression.

Conclusion

Thus we see that the policy of reducing Repo and Reverse Repo rates is essentially bad for the economy in the long-run because it greatly aids the creation of the business cycle. It also hurts ordinary people by sending prices soaring. Industry and the banking system, however, benefit in the short run. This explains why a policy of lowering repo and reverse repo rates finds fairly broad-based support from the banking industry and general industry as well.

Understanding the impact of RBI’s Repo and Reverse Repo Rate Cut
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6 thoughts on “Understanding the impact of RBI’s Repo and Reverse Repo Rate Cut

  1. Akhil hegde

    Hi Professor

    Was curious to know about fractional banking (shadow banking) in India, ran a search on google and found your website wasn’t surprised when you confirmed it that it does exist in India. West has been brought on its knees by this banking mob and am sure we would be next.

    I am reading your articles for quite some time and i really like your views on free market. A lot of them may be surprised by your views but not me. I love economics but not that which is been taught in our schools or colleges. i like the Austrian school of thought and a great believer of it. I think a lot of them are clueless that there exists different schools of thought in economics. they are clueless about people like Mises, Hayek, Rothbard, Bastiat, Hazlitt, Friedman (Chicago) etc. They don’t know what Liberty is ( jefferson, locke, john stuart mill) who are they. Thanks to mainstream media and corrupt journalism. i didnt have a clue either but thanks to my curiosity and google i was able to know who these guys are and i have made a commitment to myself that i will spend the rest of my life in making people aware of liberty. i hope we had a guy like Ron Paul (Texas Congressmen) in this country.
    Was talking to a colleague at my workplace regarding inflation she said that it was bound to happen cuz in the log run prices always rise without knowing what was the reason behind it. they find taxation to be fine without realizing that it is a form of slavery.

    Any ways just wanted to confirm whether you find anything wrong with the realestate market in India. To me it seems Frothy. these valuations cannot be sustained and i feel a lot of them would be burning their had come 2014 – 2015 the coming great depression aka deflation (failed attempt by central banks to reflate)

    at the end i would like to end with this quote

    “A patriot must always be ready to defend his country against its government ”
    – Abbey, Edward

    Reply
  2. Bala Post author

    Hi Akhil,
    First, please don’t “Professor” me. I am no “Professor”. You can just address me “Bala”. That’s good enough. Second, answering your question, like you I do find something seriously wrong with Real Estate. It is indeed very frothy. The simple indication is the complete disconnect between rental prices of vacant land and whole land prices. In fact, the very difficulty in renting out vacant land is created by intense speculation on future land prices. All this is fuelled by massive amounts of credit expansion and monetary inflation by the FRB system. So, I, for one, am not bullish about RE. I would advise anyone asking me for advice to tread cautiously after thoroughly understanding various dimensions including policy and the economic environment.

    Reply
    1. Neha singh

      Hi sir will you give proper analysis of Rbi grade B tier 2 exam 2016 and how one can get good marks in it specially in finance and management section.T

      Reply
  3. Venkatesh

    Bala,
    The way you explained was good. I am eager to know about the end to end business of Banks.Can you give information this.

    Thanks

    Reply
  4. Karan

    Hi Guys,
    Can you help me to understand how Repo rates increase or decrease interest rates.
    I have basic understanding that increase/decrease in repo rates will increase/decrease interest rates.
    But in what proportion? Because I had take Home loan from HDFC in Aug 2012 for interest rate of 10.5%. But it has changed from10.5% to 10.4% to 10.65% and now to 10.75%.
    As per my inderstanding total reduction in repo rates where higher that total increase in repo rates form Aug 2012 to Dec 2013. So why has my interest rates increased from 10.5% to 10.75%?
    Please help.

    Reply
  5. Abhishek Nirban

    Dear bala…
    I’m preparing for civil services. Quality of your answers is very good and expression is beautiful. Please help me in preparing my economics in terms of clearing civil services.
    Can you please tell me your email id

    Regards
    Abhishek

    Reply

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