In a move to reduce parking of money by the banks with Central Bank, RBI reduces the reverse repo rate by 25 basis points while keeping the repo rate constant.
The Indian economy was already in a phase of slow down since 2018. With the economic activities stalled due to widespread COVID 19 pandemic, the situation has become much worse. The most common step taken by central banks across the world is to reduce interest rates. RBI has also moved ahead on a similar path to boost demand in the economy
What are repo and reverse repo rates?
RBI introduced the system of Liquidity Adjustment Facility (LAF) in 2000. As the banks need liquidity to manage their daily need and availability mismatches, RBI helps them with this through LAF. While lending the money to the banks, the transaction occurs at repo rate. While the opposite i.e. when banks lend to the RBI, the transaction occurs at reverse repo rate. The reverse repo rate is always kept lesser than the repo rate.
The repo is short for repurchase agreement which means that the seller promises to repurchase the bonds, which it selling today, at a later specified date. Under the normal circumstances when the economy is growing, the repo rate is the benchmark interest rate because it is the lowest rate at which funds can be borrowed. Thus it forms the floor rate for all other interest rates in the economy.
Is the reduction entirely due to COVID-19?
Over the last couple of years, India was going through a slowdown in economic growth. Based on various factors it was manifested in the lower consumer demand. Also, the huge amount of previously accumulated NPA’s coupled with strict vigil from central banks made banks too much risk-averse. This resulted in banks from holding back from making any fresh investments which in turn reduced the demand for money from RBI. Thus RBI was already on a path of reducing the lending rates in order to boost the investment cycle. The repo rate was reduced earlier thereby reducing the earlier connected reverse repo rate. The spread of Coronavirus pandemic further aggravated the situation.
Why extra reduction in reverse repo now?
With the continuous decrease in demand for fresh investments, banks are flooded with high liquidity. In the dynamic situation of corona-virus affected global economic slowdown, the banks find it safe to park their excess money with the central bank. The banks have largely using the reverse repo transactions to park money with the RBI rather than repo transactions to borrow. As of April 17, RBI had close to 7 lakh crore of banks’ money parked with it. Thus making the reverse repo rate the most influential rate in the economy.
Realising the trend, RBI has cut reverse repo rate more than the repo rate twice in the spate of last three weeks. Currently, it stands at 3.75% with a cut of 25 basis points. The step is aimed towards making RBI less attractive as an option for banks to park their excess liquidity because doing so hurts the economy. The banks will be forced to lend to the capital-starved businesses.
Read More: RBI’s EMI moratorium FAQs
Will the step work?
The effect of change of interest depends on a variety of factors. First of all, it depends on demand from the consumer in India. If the demand disruption caused by coronavirus outbreak in the country continues for a long time, the business world would feel no need to borrow heavily to make fresh investments. In the opposite scenario, if the consumer demand goes up, the credit demand will also move upwards.
Another factor is the banker’s situation. If the bankers worry too much about the NPAs and are not confident about fresh loans, they might not actually pass on the benefits of reduced rates to the consumers.
Thus not only the RBI, but the businesses and banks also have to feel confident that the consumer demand will rise up once the lockdown is lifted and life goes back to normal. Otherwise, the steps will result in nothing more than a liquidity trap.
Covid-19 India Outbreak – 20th April’2020
India reported 1,580 new Covid-19 cases taking toll of the total confirmed cases to 18,539 as of 20th April’2020. The positive news for India is jump in the recovered case by 419 with 3273 recovered cases. The Covid-19 disease has taken 592 deaths in India. Among all the states the top 3 states with most number of cases are Maharashtra(4,666), Delhi(2081) and Gujarat(127).
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