What is a Repo? A ‘repo’ is nothing but a ‘repurchase agreement’. Even normal individuals can enter in a repo agreement. I give you a signed piece of paper in exchange for Rs. 10k. The paper states that “I will repurchase the signed piece of paper from you at a given date in the future for Rs. 11k.” The Rs. 1k or 10% is the ‘Repo Rate’. In the case of repo agreements between a central bank and commercial banks, the piece of paper is called the ‘Repo Rate Agreement’.
Why does the central bank do this? Because a central bank needs to control the ‘cash in the system’, so to say. That’s in their job description. In order to do that, they usually put up a handful of rules, the primary being the reserve requirements for banks and the ‘repo’ rates.
What are the reserve requirements? In India, the RBI has told the banks that they need to have a CRR (Cash Reserve Ratio) of 4% and a SLR (Statutory Liquidity Ratio) of 21%. This simply means that for every Rs. 100 that a bank has in its hands, it needs to give for safe-keeping Rs. 4 in hot cash and Rs. 21 as mostly investment in government bonds to the RBI. This Rs. 25 acts as a guarantee of sorts in case the bank collapses.
Where does Repo figure in this? Let’s suppose that a bank has only received Rs. 100 worth of deposits. The bank gives the RBI Rs. 25 by way of maintaining the CRR and SLR. Slowly, the bank lends out the remaining Rs. 75 to its customers. Now, the banks figures out that there is still some demand for loans. It’s out of money though. So the bank tells the RBI “Hey, lend me Rs. 50. I’ll give you back Rs. 12.5 by way of CRR and SLR. Let me utilize the remaining Rs. 37.50 for my business.” Remember, the RBI prints money. The RBI can never run out of money to lend, unlike the banks. The RBI replies “Fine, take this Rs. 50. But for your SLR requirements, you will have to purchase government bonds from me. So, at a given date in the future, you will repurchase your agreement from me at Rs. 50 plus 6.50% interest per annum and I will repurchase my government bonds from you at 6.00% per annum.” The first part of the agreement, where the bank repurchases its agreement from the RBI is called the Repo Agreement. The second part of the agreement, where the RBI repurchases its government bonds from the bank is called the Reverse Repo Agreement. You might have noticed that the Reverse Repo Rate is always lesser than the Repo Rate. That’s one of the perks of being the controller of the banking system of the country.
The central bank and the commercial banks engage in these repo transactions (Called ‘Repo Rate Auctions’) very often. The repo is basically how money flows from the central bank to the banks and into the system.
Why does the Repo Rate matter so much? So, we’ve seen how a repo works, both generally and in the banking system. But why does the 6.50% matter so much? Every two months, the RBI does a policy review. The most important part of it is the modification of ‘key rates’ (Repo, CRR, SLR, MSF), if any.
Indian banks are currently ‘borrowing’ from the RBI at 6.50%. Imagine that the RBI announces a 50 Basis Points ‘rate cut’. The 6.50% drops to 6.00%. The banks can now borrow more and pay lesser interest to the RBI. Higher cash in the hands of the bank will mean higher lending from the banks to the public. Higher cash in the hands of the public means more spending on goods and services. More spending and demand leads to inflation – or rise in prices of goods and services. The public starts suffering from inflation.
The RBI now intervenes and increases the Repo Rate, to say 7.25%. Now, the banks can borrow only lesser and pay a higher interest rate on it as well. You can probably fill in the gaps of what will happen next based on what we saw above. This gradually leads to a recession. The RBI again intervenes and ‘cuts’ the rate, again. It’s a vicious cycle and a cycle which needs to be monitored closely. Ineffective monetary policy will lead to depression, hyper-inflation and all sorts of economic anomalies. Although the Repo Rate is not the only weapon at the disposal of a central bank, it’s the quickest and deadliest.
Alice Rivlin, the former Vice-Chair of the U.S. Federal Reserve puts it in a nutshell: “The job of the Central Bank is to worry.”
P. S. Incidentally, ‘Bps’ or ‘Basis Points’ refers to decimal places. 10 Basis Points is equal to 0.10%, 25 Basis Points is equal to 0.25% and so on.
This article was written by Dinesh Sairam (PGDM, Batch 21, XIME-B)