What is Repo Rate ?
Posted by sushilgirdher on 14th November 2008
The Repo Rate is the official short term lending rate set by the Reserve Bank of India (RBI).
Repo is short for repurchase, and the full form is repurchase agreements. Outside of India, a repurchase agreement is usually a private interbank borrowing and lending practice. Banks will own certain kinds of what are known as liquid assets, usually government bonds, or the highest rated corporate debt which are short term in nature, ensuring that they have the deepest markets.
If a bank needs to raise cash or wants to borrow, then, it enters into an agreement with another bank that has money to lend, and it puts up these liquid assets up that is owns as security, and pledges to repurchase them at a later date and at a higher price in the future. The increase in price that the lending bank receives when it sells back those securities to the borrowing bank, represents the interest that the lending bank receives on making such kind of loans. Usually the interest is dependent upon the things one normally expects would determine the cost of borrowing, credit worthiness of the borrower, liquidity of the securities put up as collateral, the term of the loan etc.
In the rest of the world, the Repo Rate is largely a private affair with banks using this method of lending and borrowing to and from one another. In India, the rate is used as a monetary policy tool and the RBI uses it as a means of setting official short term interest rates.
Instead of banks transacting with one another, borrowing and lending from each another using such agreements, they tend to transact with the RBI instead. This is largely due to the fact that the majority of banks are government owned public sector banks, which control 80% of India’s deposits; it is perhaps easier and also cheaper for such banks to conduct open market short term borrowing and lending operations with a central clearing house like the RBI rather than deal with each other directly.
The other reason the Repo Rate is used as a monetary policy tool, is that under Indian banking regulations, banks are required to hold a large proportion of their liquid assets (i.e. funds they have not used to make cash advances to their customers with) in government securities rather than corporate debt (A market for corporate debt in India is almost non-existent), since the issuer of assets held as security is unique, it is far easier to set a standardised rate.
In most countries there are similar mechanisms whereby banks can pledge collateral to the central bank and borrow against it. In fact in America, the use of this financing technique has increased dramatically over the last year, and has been expanded since the failure of Lehman Brothers. The Federal Reserve, the US central bank has allowed even non banking finance companies such as Investment Banks to borrow from them using this method, and they have been increasingly liberal in what securities they will accept as collateral. This in fact was the only alternative available to them to ensure there was some liquidity remained in the market since the credit crisis froze short term interbank lending completely towards the middle of September.
A Reverse Repo is exactly what the name suggests, and is the opposite process of a repurchase agreement. A Reverse Repo is an open market operation of the RBI and is used as a means of borrowing back from individual banks in the Indian financial system rather than lending to them. The RBI engages in such an operation when it feels there is too much liquidity in the system, it is a short term method of mopping up cash rather than issuing bonds outright or tightening the Repo Rate which would also do the same thing.
The other monetary policy tools the RBI has in its arsenal, is the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). The Cash Reserve Ratio is the amount of funds that commercial banks must keep with the RBI as cash. If the RBI decides to increase this ratio, the available amount that banks have to lend falls and vice versa. Similarly the SLR is the proportion of deposits that banks must hold as government bonds, and the RBI can use either of these two ratios to either add or reduce liquidity in the financial system.
Central banks use monetary policy to control money supply, the main reason they do this is to try and limit inflation. The most basic reason for inflation in economic theory is that there is too much money chasing too few goods, which is why prices end up rising. Hence it is the central bank’s mandate to try and keep a lid on inflation by ensuring money supply is monitored and not allowed to expand uncontrollably.
Central banks are also faced with the conflicting goal of maintaining growth and ensuring that money supply is not too tight nor interest rates too high as a result. High interest rates have the effect of reducing investment which impacts economic growth negatively. The higher the interest rate, the less demand there is for private firms to raise capital, because it costs more and the less investments they make as a result.
India is one of the few countries to use Repo Rates as a benchmark for official lending rates. In most other countries Repo Rates are usually associated with interbank borrowing and lending practices and are usually unofficial. For reasons mentioned earlier, the RBI uses the Repo Rate as its official short term lending policy. As of October 20th this year, the Repo Rate stood at 7.5 percent. The CRR stands currently at 5.5 percent whilst the SLR is a whopping 24%.
The Government should not be eating up close to a quarter of all retail and corporate deposits. Though western banking systems are probably looking at the Indian SLR with some envy right now, because it would have meant that their banks would have made less risky loans, that is no way to run an economy. Indian Government debt as a proportion of GDP is unhealthy and such a regulatory regime will only ensure that situation persists. Excessive Government borrowing results in higher interest rates for everyone and means that less private investment takes place constraining long run sustainable economic growth.
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