Explained: What is reverse repo rate, what does it signal?

There is something called “liquidity in the banking system”, which is the daily idle cash that banks may have. Sometimes they may have no idle cash and in fact,  “liquidity in the banking system” may be tight. In such a situation, banks will be borrowing from each other or from RBI.

When the banking system has excess idle cash (like right now) the “reverse repo rate” becomes more important, because all banks are lending to RBI. The yield curve starts from the reverse repo at such times. A yield curve plots yields or interest rates of bonds (that have equal credit quality) against maturity dates. Its slope can give an idea of interest rate changes.

Alternatively, when banks have a liquidity shortage, they are borrowing from RBI at the repo rate. So during liquidity deficient times “repo” rate becomes important.

The reverse repo has become important because since the virus hit (i.e., from March 2020). RBI has ensured there is surplus liquidity in the system by buying bonds and dollars and printing money and giving it to banks in exchange. Given the surplus liquidity in the system, RBI has been focussing more on the “reverse repo” end of late.

Like for repo rate, the big reason for a likely reverse repo rate hike is inflation. When liquidity is aplenty, banks drop their deposit rates. SBI’s savings deposit rate is as low as 2.75 percent. For a saver, this is unfair because inflation is running at 4.5-5 percent. Technically we are punishing savers for saving. Also remember, the MPC has to keep CPI at 4 percent (+/- 2 percent). Today inflation is at 4.6 percent but is expected to hit 6 percent in 2022. So a rate hike is overdue, some will say.

Secondly, 3.35 percent reverse repo rate plus abundant liquidity in the system has made short term money dirt cheap. RBI is bound to worry that ultra-cheap money can be unwisely borrowed and spent because it costs so little. By raising the reverse repo rate, RBI can nudge short term rates higher but will leave long term rates intact.

Finally in normal times, the reverse repo rate is only 25 bps below the repo rate. Reverse repo was brought 65 bps below repo in April last year (lockdown – during the first wave) to make life easier for stressed borrowers. But now the extreme stress in the economy is gone, so RBI may want to bring down the gap between reverse repo and repo, by raising the reverse repo rate.

Yes, today a lot more money is lent via bonds/market instruments than earlier. But bank lending still dominates. Bond markets become active when there is plentiful liquidity. I am not sure if there is an enduring change in Indian bond markets. It’s still a thin market, with very few corporate bonds traded.