Nobody could have asked for more, even in their dreams.
India’s central bank, yet again, has gone for an out-of-turn cut in its policy rate.
Yes, it is a rate cut even though unlike on 27 March, when the Reserve Bank of India (RBI) announced its last rate cut, the six-member Monetary Policy Committee (MPC), its rate setting body, has not been involved this time around.
RBI governor Shaktikanata Das did not need to convene an MPC meeting for the Friday action because this has not been a repo rate cut; it’s a cut in reverse repo. But since 27 March, the reverse repo has become the policy rate.
Let me explain why.
By definition, the repo is the rate at which the RBI infuses liquidity in the banking system and reverse repo is the rate at which it drains excess liquidity.
The repo rate is the policy rate which goes up or down, as decided by the majority of the MPC members, keeping in mind the growth-inflation dynamics. The reverse repo rate, in contrast, is purely a liquidity management tool. Hence, the RBI can tinker with it; MPC has no say here.
Till now, the story is fine but the repo has ceased to be the lone operating rate in Asia’s third largest economy in past fortnight.
The shift happened after the RBI stopped holding reverse repo auctions post 27 March policy. Till that time, the central bank was conducting a fortnightly reverse repo auction and banks used to keep money with the RBI through this route earning just a fraction below the repo rate.
This means, when the repo rate was 5.15 per cent (till 26 March), the RBI used to take money from banks through the fortnightly auctions at 5.14 per cent. It demonstrated the sanctity of one operating rate – the repo rate.
This was beside the normal reverse repo window where banks could park excess liquidity at 4.9 per cent.
In other words, till the last rate cut, the 5.15 per cent repo rate was the policy rate and the reverse repo was pegged at 4.9 per cent. The gap between the two rates (the so-called liquidity adjustment corridor or LAF) was 25 basis points (bps). One bps is a quarter of a percentage point.
In the last policy, RBI cut the repo by 75 bps to 4.4 per cent and brought the reverse repo rate down by 90 bps to 4 per cent, widening the gap or LAF from 25 bps to 40 bps. Now, the reverse repo rate is down by 25 bps to 3.75 per cent.
By stopping to hold the reverse repo auction since then, the RBI had actually cut its policy rate in March not by 75 bps but by 90 bps. Now, by cutting the reverse repo rate further to 3.75 per cent, in little over a fortnight, the RBI has, for all practical purpose, cut its policy rate by 140 bps – from 5.15 per cent to 3.75 per cent.
The repo is the policy rate when liquidity is tight in the system and reverse repo dons the mantle when there is excess liquidity – which is the case now. How much excess liquidity is there in the Indian banking system? The RBI statement says on April 15, the amount absorbed under reverse repo operations was Rs6.9 trillion.
Why has the RBI cut the rate? This has been done to stop lazy banking. The banks are being encouraged to lend instead of parking their resources with the RBI and earn risk-free interest income. When the savings rate is down to 2.75 per cent, just by parking the money at the reverse repo window, a bank can earn 1 per cent.
The cut in reverse repo will be a disincentive to the commercial banks to keep money with the central bank. The other option before the RBI is fixing a limit on how much money a bank can dump on its reserve repo window. Instead, what RBI has done is a rate cut, by stealth.
Historically, the gap between repo and reverse repo has varied between 25 bps and 300 bps. It was 25 bps till the March policy. During uncertain times, it goes up.
Das has said there is scope for action as the inflation is on a decline trajectory. He has also reiterated that the RBI would monitor the evolving situation continuously and use all its instruments to address the daunting challenges posed by the pandemic.
We will wait and watch. For now, the governor has used the reverse repo instrument smartly. He can do it again and widen the gap between repo and reverse repo further.
For the record, the RBI introduced repo as a liquidity management tool, signaling a fundamental change in the conduct of the monetary policy, in June 2000. The use of repo and reverse repo marked a migration from direct instrument of monetary control such as bank rate to indirect instruments in a market-based economy.
As a prelude to that, an interim liquidity adjustment facility or ILAF was introduced in April 1999.