Reverse Repo Normalisation

Before understanding the concept of reverse repo normalisation, it is necessary to know about repo rate and reverse repo rate, as well as their applications, use case and significance for the monetary system and the economy as a whole.

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Repo Rate

The repo rate is the interest rate at which the Reserve bank of India (RBI) loans to its borrowers in exchange for government securities. A decrease in the repo rate enables commercial banks to obtain funds at a lower cost, whereas an increase in the repo rate discourages commercial banks from obtaining funds as the rate rises and becomes more expensive. The borrowing and lending costs for banks will rise as the repo rate rises, discouraging the people from borrowing and encouraging them to deposit. When interest rates are high, credit availability and demand fall, resulting in lower inflation. The increase in the repo rate and reverse repo rate is a sign of policy tightening. The repurchase agreement (repo rate) also becomes the benchmark rate of interest in the economy under normal circumstances, that is, when the economy is developing at a healthy rate. The repo rate serves as a floor for all the other interest rates in the economy, including those for car loans, house loans, fixed deposit interest, and so on.

Effects of Increase in Repo Rate

• Costlier for banks to borrow money from the RBI, resulting in lesser lending by banks.
• Causes deflation when other parameters are normal.
• Interest rate of loans offered by banks increases.
• Interest rate offered by the banks on the money parked by the individuals in the bank account increases.

Effects of Decrease in Repo Rate

• Cheaper for banks to borrow money from the RBI, resulting in higher lending by banks.
• Causes inflation when other parameters are normal.
• Interest rate of loans offered by banks decreases.
• Interest rate offered by the banks on the money parked by the individuals in the bank account decreases.

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Reverse Repo Rate

The interest rate at which the RBI accepts money from the commercial banks for being parked with it, is known as the reverse repo rate. An increase in the reverse repo rate means that the bank could park their money with the RBI, giving them higher and guaranteed interest, with this the RBI removes money from the circulation. The increased repo rate discourages banks from lending and hence it theoretically leads to reduction in general inflation. A decrease in the reverse repo rate means that it is more profitable for banks to lend money rather than parking it with the RBI. This leads to more liquidity in the market and it theoretically results in the rise of general inflation.

Effects of Increase in Reverse Repo Rate

• More profitable for banks to park money with RBI instead of lending to the market, resulting in lesser lending.
• Reduction in money supply in the economy.
• Causes deflation when other parameters are normal.

Effects of Decrease in Reverse Repo Rate

• Less profitable for banks to park money with RBI instead of lending to the market, resulting in higher lending.
• Increase in money supply in the economy.
• Causes inflation when other parameters are normal.

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Fact: The Repo and Reverse Repo auctions are open to all Scheduled Commercial Banks (except Regional Rural Banks) as well as Primary Dealers (PDs) possessing a current account and an SGL account with the RBI.

Fact: Primary dealers are RBI registered entities with the licence to buy and sell government securities. They are entities that purchase government securities straight from the RBI (the Reserve Bank of India issues government securities on behalf of the government) with the intention of reselling them to other investors.

Reverse Repo Normalisation

Reverse repo normalisation simply means the rise in the reverse repo rate. It is conducted in one or more stages to remove excess liquidity from the market. The main goal of reverse repo normalisation is to curb rising inflation in an economy. It also leads to increase in interest rate across the services in the whole economy, thus it becomes costlier to borrow any kind of loans and more profitable to park money in the bank accounts or FD/RD.

Money Supply Control Tools used by RBI

The central bank’s tools for controlling money supply could either be quantitative or qualitative in character.

Note: To read in detail about Cash Reserve Ratio, Repo Rate, Reverse Repo Rate, visit the attached link.

Recent Developments

• The State Bank of India stated in a recent report that it believes the ground is ready for Reverse Repo Normalisation in India.

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