Is repo RBI’s policy rate?

India adopted the flexible inflation targeting (FIT) framework in February 2015 and in May 2016, the RBI Act (1934) was amended to provide statutory basis for its implementation. This led to the constitution of an empowered six-member Monetary Policy Committee (MPC), with an aim to achieve an inflation target to be set by government of India in consultation with Reserve Bank of India once in every five years. For the period August 5, 2016, to March 31, 2021, Government of India (GoI) has notified 4 per cent Consumer Price Index (CPI) inflation as the target, with 2 per cent and 6 per cent as lower and upper tolerance limits, respectively.

Under the FIT framework in its current form, “repo rate” works as the policy rate which is determined by the MPC based on the assessment of the macroeconomic condition and with the aim to keep CPI inflation near 4 per cent. It is important to emphasise that out of many monetary policy instruments such as reverse repo rate, cash reserve ratio (CRR), statutory liquidity ratio (SLR), bank rate, etc., only determination of repo rate falls under the ambit of MPC.

Others are determined solely by the RBI. The efficacy of repo rate in maintaining price stability while keeping the economy on a sustained growth path depends on the transmission of repo rate changes by the MPC over the entire spectrum of interest rates such as money market rates, bond yields, bank deposits and lending rates, and asset prices such as real estate, and stocks. Once the transmission happens, many economic agents such as households, government, and firms adjust their spending/investment behaviour in response of these interest rate changes, which alters the aggregate demand/supply of the economy.

Therefore, for the current flexible inflation targeting regime, of which MPC is the nodal body, to be effective the single most important factor is the transmission of policy (repo) rate change first to the weighted average call rate (WACR) and then to the other interest rates.

Onus on RBI

In the current scheme of things, MPC is only responsible for setting policy (repo) rate, and the onus of performing the liquidity operations to operationalise the monetary policy lies with the RBI. The RBI’s liquidity management framework is primarily based on the corridor system. The corridor system, generally, requires interbank liquidity to be slightly in deficit mode to work efficiently. Because, for the repo to transmit to the WACR, the liquidity in the system must be short of the needed amount of liquidity. If, on the other hand, the liquidity is in excess, the banks don’t demand liquidity in the overnight market and hence, the WACR remains separated from the repo rate. Since the RBI can control the liquidity in the market through tools outside the purview of the MPC, it can use them to make the MPC irrelevant by having excess liquidity in the system on a durable basis. This is precisely what has happened over the last few months.

Refer to Chart 1 which shows the Indian banking system liquidity index. Read this chart as the total liquidity demanded by the banks in India. Hence, when positive, it reflects that liquidity demand is high and when negative, it implies that the banks are lending more to the central bank instead of borrowing from it. As is evident, from the second half of 2019, liquidity in the banking system has been in excess.

In such a situation, banks are unlikely to borrow in the interbank market, and hence no matter what the repo-rate changes are, they will not be efficiently transmitted to the real economy. Infusion of liquidity in the system is done outside the purview of the MPC, through instruments such as CRR, unconventional policy tools, SLR requirements and open market operations.

In order to ease the liquidity conditions for banks, the RBI has taken steps such as reducing the CRR by 100 basis pointss, introducing a special borrowing facility to an extent of 1 per cent of the SLR securities and targeted long term repos (TLTROs). While auction of over ₹1 lakh crore worth of TLTROs has been completed so far, reverse repo auctions of ₹136.73 lakh have been conducted since the announcement of the TLTROs. As a result of this, the RBI has in effect sucked short term liquidity from the system, while providing longer term targeted liquidity.

Are the actions justified?

This excess liquidity in the banking system, evident from the large reverse repo auctions, effectively invalidates the repo rate, as banks, flush with liquidity need not borrow at the policy rate. Given that the RBI has the mandate to implement the policy rate, are these actions justified? Is repo RBI’s policy rate? What consequence does it have on the interbank borrowing rate?

For an answer to the second question first, refer to Chart 2. RBI operates the corridor system of interest rates where the ceiling of MSF rate and the floor of reverse repo sandwiches the interbank rate (WACR). For the repo rate to be the policy rate governing the interbank borrowing, the WACR should be close to the repo and, at times, it may even exceed the repo if the banks are short of liquidity. If instead, it is closer to the discretionary reverse repo, it indicates that the system has excess liquidity and the interbank rate is detached from the repo.

This implies a failure of transmission of the policy rate, especially when the reverse repo itself could be detached from the repo. There are two things to notice in the chart. First, since the turn of the year, the WACR has drifted away from the repo/MSF, towards the reverse repo floor, showing the consequence of excess liquidity in the system and the unwillingness of the banks to borrow in the interbank market at the policy rate. Second, the corridor seems to have started widening and has gone beyond the prescribed limit of 0.5 per cent. Hence the discretionary reverse repo, which is becoming the policy rate, is itself drifting away from the repo. The policy rate is no longer the repo, but the reverse repo.

Given that the RBI’s liquidity operations are predominantly liquidity sucking rather than liquidity providing (see the rise in reverse repo operations in the recent months), the RBI has effectively become a customer of the excess liquidity of the banking system. In the process, in the year 2020, assuming that the reverse repo amounts are deposited only overnight (longer duration would imply larger interest, hence our figure merely provides a lower bound), the RBI has spent on an average ₹15 crore per day in the form of interest on reverse repo amounts.

Why the slack in lending

A related question is why the banks are flush with liquidity and unable to lend to eligible borrowers? First, the purpose of infusing liquidity in the system was to support the debt instruments that are experiencing price pressures due to outflow of money, especially the smaller NBFCs, where 50 per cent of the TLTRO funds have to be invested. Banks are finding it hard to invest this money as they find these securities too risky given the current situation. As a result, they may end up paying a penalty of 2 per cent above the repo rate on the money borrowed under TLTROs.

Second, industries are facing a labour crisis and are unlikely to make investments in order to increase capacity. In this situation, liquidity infusion in the system is unlikely to yield results, for the want of demand for credit by the industry. Banks, in short, are unable to find eligible borrowers that can provide good returns, while they kick start the economy by putting the borrowed money to productive use.

As a result of RBI’s actions, the MPC has become redundant. In the current excess liquidity conditions, the MPC’s inflation targeting repo is unlikely to be transmitted to the banking system. This stands in direct contradiction to the mandate that the RBI has to implement the policy rate through its actions. More importantly, the reason why the RBI has deviated from the goal does not seem to be bearing fruits.

The writers are doctoral students at IIM-A. Views are personal