RBI seeks tighter grip on rates via ‘term repo’

After consistently catching the markets unawares in his last three policy reviews, the RBI Governor decided to surprise in a different way this time — by doing nothing. He kept markets happy by maintaining status quo on the key repo rate.

But banks’ cost of funds may still inch up, thanks to the new cap on overnight borrowings at the repo rate. However, with banks actually sourcing only a minuscule portion of their funds from the repo window, this will not have a significant impact on either the deposit or lending rate.

But the bigger signal from this policy review is that the RBI is determined to make the repo rate irrelevant over the long term. The ceiling on borrowing under the repo window is a clear step towards adopting the Urjit Patel Committee’s recommendation — that the RBI stop fixing the repo rate in its quarterly reviews, and instead move to rate-setting on an ongoing basis.

Such ‘on the go’ rate setting is expected to give the central bank a tighter control over market rates. This will also help borrowers know which way lending rates will move in future.

The repo rate, the fixed rate at which banks borrow from the RBI via the liquidity adjustment facility (LAF) window, has been left unchanged at 8 per cent. But the amount that banks can borrow under this window has been reduced. Banks can now borrow only up to 0.25 per cent of their deposits, which is half the amount that was available earlier under the LAF.

But this shortfall in funds will be made good by the new ‘term repo’ provided by the RBI. The ‘term repo’ window allows RBI to supply funds from time to time, with banks bidding for the rates at which they will borrow this money.

The impact of term repos is two-fold. One, it can cause a spike in bank’s costs of funds. Banks borrowed an average of ₹31,000 crore daily under the LAF window in the last two months at the fixed repo rate of 8 per cent.

But the 14-day term repos which were auctioned at 8.2 per cent in the beginning of March were priced at 8.8 per cent towards the end of the month, due to the tight liquidity situation.

Thus, by capping the amount borrowed at the repo window, the RBI is nudging banks to borrow at higher rates; the weighted average cost of funds for banks may go up by 20-40 basis points.

The second fallout of the term repos is that banks may have to stop relying on the RBI for liquidity support at a fixed rate and instead adapt to ‘floating’ rates that RBI prefers to accept on each auction.

The RBI will thus gradually migrate market participants from watching the repo rate to the target rate that it sets for its 14-day term repo.

What does this mean to you? Right now, rates on short-term deposits and debt instruments may remain firm; and your equated monthly instalment (EMI) is not expected to inch up anytime soon.

As the year-end scramble for liquidity eases, and the term repos are auctioned at lower rates, the cost of funds for banks may moderate.

In recent times, even when the RBI cut policy rates, banks seemed reluctant to pass on the benefit to borrowers.

Thus the repo rate as a policy tool has been rather ineffective. However, now, through term repos the RBI can control both the liquidity as well as the rate at which it provides funds to banks.

Hereafter, by tweaking the amount of liquidity that it provides to banks at each auction, it gets to set the market rates for short-term money at levels that it targets.

This shift is likely to eventually help borrowers, by ensuring that any change in policy action will quickly reflect on banks’ lending rates.