The Reserve Bank of India (RBI) and its attempt at managing liquidity, inflation and growth through its monetary policy has been constantly in the news. And its decision to cut rates or not has become the subject matter of much non-economist discussion. You know that monetary policy is RBI’s primary responsibility but may not know the tools that RBI has at its disposal. There are five main policy tools that RBI uses.
Repo and reverse repo rate
Repo is a transaction wherein securities are sold by RBI and simultaneously repurchased (hence, the term repo) at a fixed price. This fixed price is determined in context to an interest rate which is called the repo rate. The transaction is relevant for banks when they need funds from RBI—so, RBI repurchases the securities—which is akin to lending money to the bank at the decided rate. The higher the repo rate, the more costly funds are for banks and hence, higher will be the rate that banks pass on to customers. If the rate is high, it signals that access to money is expensive for banks; lesser credit will flow in the system and that helps bring down liquidity and lowers inflation. The reverse is the reverse repo rate which is used by banks to park excess money with RBI. At present the repo rate is 7% and reverse repo is 8%.
Cash reserve ratio (CRR)
This is the percentage of a bank’s time and demand liabilities that needs to be kept as cash with RBI. RBI can vary the percentage up to a limit. A high percentage means banks have less to lend and hence, curbs liquidity and a low CRR does the opposite. RBI can use the CRR to tighten or ease liquidity by increasing or decreasing it as the situation demands. At present, CRR is at 4.75%.
Open market operations
This refers to buying and selling of government securities by RBI to regulate the short-term money supply. If RBI wants to induce liquidity or more funds in the system, it will buy government securities and inject funds into the system, and if it wants to curb the amount of money out there it will sell these to the banks thereby reducing the amount of cash that banks have.
Statutory Liquidity Ratio
Banks are required to invest a percentage of their time and demand liabilities in government approved securities, this is referred to as the SLR. At present it is at 24%.
This is the re-discounting rate that RBI extends to banks against securities such as bills of exchange, commercial papers and any other approved securities. In recent years it has been the repo rate rather than the bank rate which acts as a guideline for banks fixing their interest rates and the bank rate is currently at 9%.
In addition to these specific measures, RBI also uses many qualitative tools through which it can regulate credit flow and cost of credit to the economy and specific sectors within the economy.