Borrower: Experts have been suggesting that RBI should bring down its policy rates further to bolster the slowing economy. What should the central bank do now?
Banker: It can bring down the policy rate to zero.
Borrower: Just now you said the policy rate cannot go down below 3.5%.
Banker: RBI can reduce it to zero through the back door.
Borrower: How?
Banker: It should stop sucking money out through its reverse repo window.
Borrower: Can’t follow it. Will you please explain?
Banker: As you know, unlike other central banks, RBI has two policy rates— repo and reverse repo. In a liquidity-starved situation, repo is the policy rate, as RBI infuses money at this rate. And, in a liquidity-surplus situation, as is the case now, reverse repo is the policy rate. Is this clear?
Borrower: Yes. Go on.
Banker: All RBI needs to do is stop taking money out of the system. If RBI does not accept money at its reverse repo window, the 3.5% rate becomes irrelevant.
Borrower: Can’t follow you.
Banker: It’s simple, my dear. Banks have enough money in their coffers and every day they park this money at RBI’s reverse repo window where they earn 3.5%. RBI opens the window twice a day. On Friday, for instance, the banking system put Rs35,250 crore in the morning and again Rs31,530 crore in the afternoon, taking the amount for the day to Rs66,780 crore. In the past two weeks, on an average, banks have been keeping Rs64,763 crore daily with RBI, earning 3.5%.
Borrower: So what?
Banker: They are not giving loans or buying bonds as they are earning at least 3.5% on their surplus funds. If RBI stops taking their money, they will be left with no choice but to look for borrowers and invest in government bonds as money has a holding cost and if they do not earn anything on idle money, their income will go down.
Borrower: Are you saying that liquidity will start chasing assets?
Banker: Exactly. The moment we know that RBI will not allow us to park money with it, we will be forced to deploy the money elsewhere.
Borrower: But can RBI do this?
Banker: Why not? It can simply put a cap on how much money a bank can keep with RBI. For instance, it can fix the limit at 1% of total deposits. Right now, the banking system has a deposit base of Rs36.8 trillion. This means that at 1%, banks can keep up to Rs36,800 crore with RBI, much less than what they have been doing now. The actual amount will be much less as all banks do not have surplus liquidity.
Borrower: So even by keeping the 3.5% rate unchanged, RBI can effectively bring down the policy rate to zero?
Banker: Yes. If I have surplus money and RBI is not taking it, I will be forced to use the money and earn something. I will bring down my loan rates and also buy bonds as something is better than nothing. A lazy banker will become a busy banker.
Borrower: Why don’t you suggest this to Governor D. Subbarao at your next meeting?
Banker: Are you crazy? I should not have discussed this at all.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as a deputy managing editor of Mint. Comments are welcome at bankerstrust@livemint.com