While the RBI’s rate cut has offered relief to borrowers, it is the substantial changes in the liquidity management that will provide borrowers more respite in the long run. After keeping liquidity in the banking system in deficit mode, the RBI has indicated to move to a neutral liquidity position over the long run. The underlying purpose of this move is to ensure quicker transmission of policy rates to borrowers.
The RBI lowering the rate corridor between the repo, reverse repo and marginal standing facility (MSF) rate will also ensure that rates fall gradually, with lesser volatility. Before the monetary policy, the repo rate — at which banks borrow short-term funds from the RBI — was 6.75 per cent. Banks not able to meet the shortfall under the repo window would borrow at the MSF rate which was 100 basis points higher. The reverse repo rate, at which banks lend their excess funds to the RBI, was 5.75 per cent.
The liquidity adjustment facility (LAF) allows banks to borrow money from the RBI under the repo window by selling securities with an agreement to repurchase the same.
So far the RBI has kept the core liquidity deficit, the amount that banks borrow through the LAF, at 1 per cent of net demand and time liabilities or deposits.
In other words, liquidity deficit meant that the market (overnight) rate hugged the policy repo rate. In times of tighter liquidity deficit, the overnight rate would lie between the repo and the higher MSF rate.
This ensured that the RBI could keep rates sticky to keep inflation under check.
Now, with the focus on better transmission, the RBI is keen on ensuring that lending rates fall more sharply. The RBI is now looking to move from a deficit regime to a neutral regime which will ensure that the overnight rate hovers between the repo and the reverse repo rate.
According to Abheek Barua, Chief Economist, HDFC Bank, since the RBI’s focus has now shifted to ensure that the transmission of the rate cuts become more effective, the lower band for the overnight rate will have an effect on the yield curve in general, pulling it down and lowering the cost of funds for banks and making it viable to lend at lower rates.
Narrow corridor Aside from a shift in the liquidity regime, the RBI has also narrowed the rate corridor to ensure a fall in rates, without much volatility. The repo, reverse repo and MSF, which operated with a 100-basis-point spread earlier, now have a differential of 50 basis points between each of them. Reverse repo, currently at 6 per cent, is 50 basis points lower than the repo rate. Hence, with the neutral liquidity regime in place, the overnight rate will hover between 6 and 6.5 per cent.
According to Barua, the compression in the policy rate corridor will likely limit volatility in the rate corridors.
But the shift in the RBI’s liquidity from deficit to neutral will not happen immediately. Given that the RBI will have to infuse around ₹1.1 lakh crore into the financial system to make the shift, it will happen over a period of, maybe, one to two years, according to Abheek.