Why are we talking about this now?
The RBI for the past few months has kept on reducing the Repo and Reverse repo rates as an effort to stimulate economic growth. Why do they do that? And the rates keep changing bimonthly. The rates are now kept at a historic low. The revised rates will again be announced in a month from now. So I thought of shedding some light on what this is so that the next time you read this news you actually understand the economics behind it.
Let us start by understanding the basic terms.
Repo: Repo is an acronym. It stands for Repurchase option. From the word you can understand there is some sale going on. It is basically the interest RBI charges for money that the banks borrow from it.
Reverse repo: This is the exact opposite of Repo, meaning the interest RBI gives for the money borrowed from the banks.
Inflation: It is the general increase of prices in the economy.
Now, the world of banking is very easy to understand. What ever operations that a bank does it boils down to just one thing. Profit. There is a person who has more money and wants to keep it in someplace safe. Then there is someone else who needs the money. Banks take money from people who have excess money and give to people who want that money. To give an incentive to the one giving money you get paid an interest and to cover the risk of lending the money, the other person is expected to pay an interest for his loan. The difference between the interest the bank pays to the first person and the interest paid by the second person is the profit for the bank.
So I had said initially that there is a sale going on when I mentioned the word Repo. What is sold? And why is it sold?Banks need money not just to run the business but for a variety of other needs (CRR, SLR etc. Don’t panic I’ll explain in further blogs) So when banks run out of money they have to borrow. From whom? None other than RBI. But banks can’t go and ask RBI “Listen I need money, Gpay it to me,I’ll repay when my salary comes next month” RBI is not your friend, it’s a regulator. So banks have to provide some security or collateral to get the loan. And the collateral has to be a well secured one. So every bank has a definite amount of Government bonds that they hold because government bonds are the most risk-free investments you can have. So they sell these government bonds to RBI to get the money with a promise to buy these G-secs back after a specific period of time at a specific rate.So RBI purchases the bonds that banks sell. And the banks repurchase the bonds after a specific time. This is what Repurchase option means. In case of any default from the bank the RBI can sell the security and get back its money.
In reverse Repo the same operation takes place, just that the sides get interchanged. Here RBI sells the bonds and the banks purchase it. The banks promises to resell the bonds at a pre-determined rate. Remember, reverse repo will always be lesser than repo simply because RBI will not pay more.
Why are these rates adjusted?
The RBI is the central bank of the country. It not just prints currency it also has an important job of controlling the inflation in the country. And remember, the policies introduced by RBI is called monetary policy and the policies announced by the central government is called fiscal policy. Both are completely different. Inflation is a complicated term but to keep things simple, it is a situation where the economy is flushed with cash, meaning there’s a high flow of cash. When there is a lot of cash the value for money decreases. How? Imagine you earn ₹100 a month and buy breakfast for ₹10 a month. Suppose you go to a bank and take a loan of ₹100. Now your income is ₹200. And let’s suppose the day you go to your canteen there is a big rush. Your server comes to you and says I know you buy your breakfast for ₹10 but if you pay ₹12 you need not wait you’ll get the food immediately. What do you do? You can afford that ₹2 extra simply because your income has increased. Now the same breakfast which costed you ₹10 yesterday becomes ₹12 today with no increase in quality or quantity. This is how inflation occurs. This is how value of money decreases. It is basically a situation where supply (of money) exceeds demand (for money). Basic economics.
Inflation is healthy to a point but after some point of time it becomes toxic. So RBI tries to remove the quantity of money in the economy and increase the quality by increasing the Repo rate. How does it happen? Well you have seen the primary income for the bank is through lending. And the only way the common man gets extra money is through loans. So when RBI increases the Repo rate banks think twice before borrowing money from the RBI. Because they have to pay higher interest. So with lesser money coming from RBI they lend less. And they have to increase the interest rates because RBI is charging them more now. The common man gets lesser incentive to borrow because he has to pay higher interest now. So he reduces his borrowing therefore reduces his spending.When there is lesser money inflation reduces. This is the theory behind increasing rates.
Suppose the economy is heading towards deflation. People start saving money and spend less. At that time the RBI reduces the Repo rate. Lesser repo rate means banks can lend you lots of money. And the influx of money will further increase spending and thereby increase economic growth. You have seen that there is a sale or purchase of government securitys in both repo and Reverse repo. When bonds are sold (repo)by the bank to RBI there is and Influx of cash into the bank and thereby into the economy. Similarly when bonds are purchased by the banks from the RBI (reverse repo) these is a suction of cash from the economy.
Okay this is peace. But why don’t you see a drastic change in your loan rates even when the Repo rate is falling drastically month after month? In fact there is an interesting study.
Why banks can’t pass the interest rates cuts directly to the customer?
The main reason here is that both repo and Reverse repo are short term borrowing. They are borrowed for a period anywhere between overnight and 7 days. That’s the maximum time period. But the loans that people take extend for 15-20 years. This is one main reason. The difference between the short term and long term rates is called the yield rate.(We’ll discuss this again separately as of now just know this)
The other important thing is your fixed deposits. When you enter a fixed deposit and the bank agrees to pay you a certain rate of interest, no matter what happens to the economy, no matter what happens to the business of the bank it will have to pay you that interest. Suppose I give you a term deposit at higher interest and the next month I start lending at lower interest how do you think I can make profit?(Recollect how a bank functions basically)
Then comes the concept of fixed and floating interest rates of loans. (again a separate topic for discussion)
Then it is because the banks operate partly on the base rate system and partly on the MCLR system. And therefore the loan rates are not directly linked to the external benchmark(repo and Reverse repo. Again don’t panic this will be discussed in this series).
So that’s the first part of Monetary policy series. I understand it’s so long but trust me I tired a lot to keep this short and this is the shortest I could keep. Also there are a lot of unexplained terms in this which I’ll be explaining in the blogs to come. Trust me in the next 3 blogs you’ll be able to understand monetary policy completely.
If you have any suggestions or any constructive criticism feel free to tell me. Your suggestions will help me improve.
Money is easier to understand. Let’s become knowledgeable and wealthy at the same time.
Until then…
Naga's mind 
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