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Home / Opinion / Views /  It’s time for correcting the reverse repo rate distortions

When the lockdown was imposed in March 2020 in response to the Covid outbreak, uncertainty shot up in the economy. With no clarity on the economic outlook, the Reserve Bank of India (RBI) was understandably keen to avert a situation where lending by banks would freeze amid so much uncertainty. To preclude lending from coming to a halt, the RBI decided to shore up liquidity that banks could tap for lending. It rolled out the extravagant TLTRO (targeted long-term repo operations) for giving funds to banks for targeted lending specific sectors. But an unpredictable pandemic made banks more cautious and risk-averse than the RBI had imagined; they did not lend the funds streamed to them on the TLTRO channel. To make it unattractive for banks to sit on cash instead of lending it, the RBI in two stages lowered the reverse repo rate, or the rate at which the central bank borrows from commercial banks, to 3.35%. It reduced the reverse repo outside of the cycle of the monetary policy committee’s meetings, sparking off a public debate in which former RBI governors took the view that the RBI had encroached upon the legal remit of the committee.

Whether or not the RBI violated the spirit of the monetary policy committee reforms, this became India’s version of easy liquidity policy for Covid. The RBI pressed ahead with it at a time when there wasn’t much appetite for loans—enterprises were unsure if and when they will be able to make enough money to repay loans. Many were on the brink of closure. With hardly any demand for borrowing, the policy had the unintended consequence of building up surplus liquidity in the system which even today is of the magnitude of 6-8 lakh crore.

Conditions have changed now. Even though there have been the second and third Covid waves, the severity of lockdowns has decreased. The economy is back on track, and even though the expected 9.2% growth rate will be an anaemic 1.3% over FY20, there is the growing problem of inflation crying for attention from the makers of monetary policy. India’s monetary policy has focused on preserving growth, sidestepping the RBI’s main mandate of controlling inflation, for too long. Given monetary policy works with lags, this dithering is likely to have adverse consequences for the economy.

The RBI has already rolled back some of the schemes it had introduced in response to Covid: It lifted the moratorium on repayment of loans last year and wound down the GSAP (Government securities acquisition programme) auctions. The logical corollary is now to realign the reverse-repo rate in with the policy that was being followed before the Covid disruption. The RBI had been maintaining the corridor between the ‘repo and marginal standing facility (MSF)’ and ‘repo and reverse-repo rate’ at 25 bps.

Today, the market is driving bond yields northwards while the RBI holds on to the benchmarks which have created an anomaly. This needs to be corrected. The market sees the scope for the overnight rate to be increased. The v3R, variable reverse repo rate, auctions that are popular now. These auctions, which are for a longer tenure, have cutoffs of 3.99% which is almost the repo rate. So, while the one-day overnight repo reverse repo rate is at 3.35%, the 7-day reverse repo rate is at 3.99%. This looks out of place. Besides, for banks, the funds that they keep in the overnight reverse repo window now have a negative carry on, as their cost of deposits is around 4-5%.

By restoring the corridor at 25 bps, the RBI will be able to will to correct the distortions that arose for the banking system when it had reduced the reverse repo rate. This will take care of both the key concerns in the market. First, banks need not increase lending rates. Second, the markets will be pleased with the move. Plus, it will send signals to the money markets that we are out of the era of easy liquidity. The banking interest rates for deposits and lending may not change, but the market will be assuaged that rates are getting realigned with the reality.

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