The RBI kept the repo rate constant at 6.5% in its bi-monthly policy review meet on October 5th. This decision was the topic of much debate as many analysts expected a hike in repo rate by at least 25 bps as crude oil prices were high and the rupee had fallen heavily against the dollar.
The RBI had opted for back to back repo rate hikes in the last two policy review meets. The repo rate was hiked from 6% to 6.5%. The current repo rate stands at 6.5%. Why did RBI choose not to hike repo rates?
RBI wanted to strengthen domestic macroeconomic fundamentals because of global factors like high International crude oil prices, slowdown in China and the US vs China trade wars. The RBI is focusing on controlling inflation with the inflation target set at 4% ± 2%.
Analysts argue that RBI should have opted for at least a 25bps hike, with the Rupee crashing to Rs 74 against the Dollar. They believe the RBI will now have to hike repo rate by at least 50 bps. Let’s understand what is the meaning of repo rate, reverse repo rate and the current repo rate.
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Repo rate is the rate at which RBI lends to commercial banks. If there is a shortage of funds, banks sell short term securities and bonds to the RBI with an agreement to repurchase at a later date. RBI charges interest on this amount called repo rate. The current repo rate stands at 6.5%.
Repo has origins in the Liquidity Adjustment Facility (LAF) launched way back in the year 2000. The repo is used to inject liquidity into the banking system. The reverse repo is used to suck out money supply from the economy.
Repo is a contract between the bank and the RBI in which banks pledge securities like treasury bills as collateral with RBI to avail overnight loans with a commitment to buy them back at a fixed price at a future date. The RBI charges interest on this amount called the repo rate.
So what is net demand and time liabilities popularly called NDTL? NDTL refers to all the deposits of the bank which includes deposits of the public and the deposits the bank has with other banks. Demand deposits are nothing but the deposits the banks need to pay on demand like demand drafts (DD), current deposits, balances in overdue FDs and even demand liabilities portion of savings bank deposits among others.
Time deposits include deposits that have to be repaid on maturity and depositors cannot withdraw this money immediately. These are FDs, staff security deposit and time liabilities portion of savings bank accounts. SLR currently stands at 19.5%.
The bank offers eligible securities which are over the SLR limits to the RBI as collateral. The repo also called repurchase agreement involves the repurchase of these securities at a later date and at an agreed price.
Repo rate is a part of the monetary policy of the RBI. It is used to regulate money supply in the economy, as an inflation targeting tool and to inject/suck out liquidity from the banking system.
How does the repo rate affect banks? If the RBI raises the repo rate (This has been happening in the last few months), then the borrowing costs of banks go up. This means RBI is sucking out liquidity from the system.
When inflation goes up, (This could be because of rising food prices), then RBI targets inflation by hiking the repo rate. As interest rate rises, borrowing gets costly for banks, industries and businesses. The hike in repo sucks out liquidity from banks. Investment slows down. Consumers postpone purchases of homes, cars, home appliances and electronic gadgets. This means there’s less demand for home loans, personal loans, car loans among others. Slowdown in investment means inflation goes down.
If the RBI wants to inject liquidity into the system, it lowers the repo rate. Borrowing costs for banks goes down. This is good for industries and businesses as investment goes up. The overall supply of money increases in the economy. Consumption goes up as people make a lot of purchases. This boosts growth rate. Sadly, inflation also goes up.
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Banks deposit surplus cash with the RBI. Interest is paid by the RBI on these amounts called reverse repo. In simple words it is the rate at which RBI borrows from commercial banks.
When there’s excess money supply in the economy, inflation goes up. The RBI increases the reverse repo rate and banks deposit idle cash with the RBI. This drains money from the banking system as banks have less to lend. Interest rates go up and individuals restrict purchases bring down consumption in the economy. The current reverse repo is 6.25%.
The US has imposed unilateral sanctions on Iran pushing up International Crude Oil prices. India imports over 80% of crude oil requirements and this has sent petrol and diesel prices sky rocketing. In spite of measures like a Central Excise duty cut of Rs 1.5 and an additional Re 1 absorbed by OMCs like HPCL, BPCL and IOC, petrol and diesel prices are quite high. All BJP ruled States have cut VAT on fuel by an additional Rs 2.5.
The recent hike in MSP (Minimum Support Prices) is expected to push up food prices raising food inflation. The trade war between US and China, weaknesses in emerging Nations currencies, political turmoil in Turkey have all lead to the Rupee crashing to Rs 74 vs Dollar. Imported inflation is affecting some industries which use imported goods in domestic manufacturing, increasing prices of certain goods and pumping up inflation.
Then you have the IL&FS crisis where some subsidiaries of IL&FS (There are around 348 of them) defaulted on commercial paper obligations. The IL&FS default was considered to be India’s Lehmann moment by many investors in India. There’s talk of an SFIO (Serious Fraud Investigation Office) investigation on fraud in IL&FS, resulting in all IL&FS group stocks hitting the lower circuit. ICRA and India Ratings downgraded IL&FS by several notches. IL&FS ratings were reduced from AAA to default D or junk status. This send bond markets into a tizzy. The liquidity crisis at DHFL didn’t help matters. Mutual funds dumped IL&FS shares as stock markets crashed.
Investors looked to the RBI to prop up the stock markets and save the Rupee. RBI raised repo rates from 6% to 6.5%. RBI held rates in the last bi-monthly policy review meet on October 5th 2018. There’s talk that RBI could go for a 50 bps hike in December.
So how does repo rate hike affect you? A hike in repo rates leads to an increase in home loan EMIs. You will not feel the effects of this immediately. Banks hike MCLR when repo rate rises or just before it is expected to be raised. Banks including SBI have raised MCLR. You will find home loan EMIs going up when the reset date of home loan arrives. You continue to pay existing home loan EMIs till the next reset date arrives. When the reset date arrives, all future home loan EMIs will be calculated based on interest rate applicable on reset date.
The hike in repo rate affects businesses as interest costs rise. Buyers postpone home purchases and there could be a slowdown in real estate.
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