In a recent report, State Bank of India has stated that it believes the stage is set for a Reverse Repo Normalization in India.
What is reverse repo?
- The reverse repo is the interest rate that the RBI pays to the commercial banks when they park their excess “liquidity” (money) with the RBI.
- The reverse repo, thus, is the exact opposite of the repo rate.
- Under normal a circumstance, that is when the economy is growing at a healthy pace, the repo rate becomes the benchmark interest rate in the economy.
- That’s because it is the lowest rate of interest at which funds can be borrowed.
- As such, the repo rate forms the floor interest rate for all other interest rates in the economy — be it the rate you pay for a car loan or a home loan or the interest you earn on your fixed deposit etc.
Reverse repo normalization
- Simply, it means the reverse repo rates will go up.
- Due to rising inflation, several central banks around the world have increased the interest rate. In India, RBI too is expected to raise the repo rate. However, before increasing repo rate, it will first raise the reverse repo rate to reduce the gap between the two rates.
- SBI first expects the reverse repo to go up from 3.35% to 3.75% while the repo rate continues to be 4%. It will incentivise commercial banks to park excess funds with RBI, thus sucking some liquidity out of the system.
Why is normalization needed?
- This process of normalization is aimed at curbing inflation.
- It will not only reduce excess liquidity but also result in higher interest rates across the board in the Indian economy.
- It will thus reduce the demand for money among consumers as they would prefer to just keep the money in the bank.
- Thus, it will make it costlier for businesses to borrow fresh loans.
What is Monetary Policy Normalization?
- The RBI keeps changing the total amount of money in the economy to ensure smooth functioning. As such, when the RBI wants to boost economic activity it adopts a so-called “loose monetary policy”.
- There are two parts to such a policy:
- Injecting Liquidity in the Economy: It does so by buying government bonds from the market. As the RBI buys these bonds, it pays back money to the bondholders, thus injecting more money into the economy.
- Lowering Interest Rate: Two, the RBI also lowers the interest rate it charges banks when it lends money to them; this rate is called the repo rate.
- By lowering the interest rate at which it lends money to commercial banks, the RBI hopes that the commercial banks (and the rest of the banking system), in turn, will feel incentivized to lower interest rates.
- Lower interest rates and more liquidity, together, are expected to boost both consumption and production in the economy.
- For a consumer, it would now pay less to keep the money in the bank — thus it incentivizes current consumption. For firms and entrepreneurs, it would make more sense to borrow money to start a new enterprise because interest rates are lower.
- The reverse of a loose monetary policy is a “tight monetary policy” and it involves the RBI raising interest rates and sucking liquidity out of the economy by selling bonds (and taking money out of the system).
- When any central bank finds that a loose monetary policy has started becoming counterproductive (for example, when it leads to a higher inflation rate), the central bank “normalises the policy” by tightening the monetary policy stance.
Implications of such policy
- Doing this will incentivize commercial banks to park excess funds with RBI, thus sucking some liquidity out of the system.
- The next step would be raising the repo rate.
- This process of normalization, which is aimed at curbing inflation, will not only reduce excess liquidity but also result in higher interest rates across the board in the Indian economy.
- This will help reducing the demand for money among consumers (since it would make more sense to just keep the money in the bank) and making it costlier for businesses to borrow fresh loans.
Source: Indian Express