What is the Repo Rate and Why Does Everyone Care So Much About It?

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.

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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)

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The Economics of a Religious Ritual

India is a very religious country. As such, there are numerous religious rituals involved. Once such religious ritual is throwing coins into ponds located within a temple. In the non-religious parlance, this can be related to throwing coins into fountains and wells for luck. How do the wasted coins affect the economy? Does the economy become poorer for all the lost wealth? Well, not quite.

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(Source: www.democraticpaper.com)

Imagine that there is a lunatic out on the loose whose sole purpose in life is to steal money from people – and burn it. Now he has successfully burnt down all but Rs. 100 worth of money in the hands of every single person in the country. Imagine now what would be the likely effect on the economy. There will be deflation, heck, depression.

People will not spend at all. They will guard their Rs. 100 with their life. They will spend it sparingly, only for food and other necessities. The prices of all other goods and services will crash. Businesses will shut down. If at all some business remains operational, their good or service will be sold at a very marginal rate. Dresses will sell for Rs. 10 or so, cars will sell for Rs. 1000 and so on (Okay, not really, but at least in theory).

Putting aside the destruction and despair, think for a moment what happened to the value of money. Before the lunatic, you could get a Lay’s chips for Rs. 10, but after the fiasco, you are able to get a dress for the same amount. The value of money increased multi-fold.

This is the economic impact of what we call ‘money burning’ in Economics. When you burn money/throw it away, you make everyone else using the same currency richer by a very, very, very tiny part. In the long term you also become richer, but of course you become immediately poorer if you burn your money/throw your money away.

For those of us economically inclined, the Quantity Theory of Money establishes exactly this. Although there are some strong critics of the theory, it holds true. Otherwise, Central Banks across the world would not have ‘controlling money supply’ as one of their major motives.

Before you try this experiment for yourself, note that destroying money is a punishable offense is most countries. This is due to the fact that money is not something you own. Money is simply an instrument created by the government to represent what you own aka your wealth. But at least, the next time you throw away a few coins into a pond, pause for a second and realize how you’ve made your country richer by a teeny-tiny part.

This article was written by Dinesh Sairam (PGDM, Batch 21, XIME-B)

Demonetisation, Modi and More

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“So long.”

In a massive move, Prime Minister Narendra Modi announced the demonetising of Rs 500 and Rs 1000 currency notes. According to Investopedia, demonetization is the act of stripping a currency unit of its status as legal tender. The idea behind the effort, as Modi suggested in a long preamble before his announcement, is to attack corruption and make black money harder to use.

This isn’t the first time India has demonitised its currency. In 1946, the Reserve Bank of India actually banned Rs 1,000 and Rs 10,000 notes, primarily to deal with unaccounted money. These were then reintroduced with a Rs 5,000 note in 1954, before they were once again demonitised in 1978.

The aim of taking the Rs 500 and Rs 1,000 notes out of circulation is to reduce the amount of illicit money in the economy. Simply put, many economists believe that high-value notes make it much easier for black money to move around the country, without necessarily being beneficial for law-abiding citizens or the poor. Next government also wanted to eliminate fake currency and dodgy funds which have been used by terror groups to fund terrorism in India. The move is estimated to scoop out more than 5 lakh crore rupees black money from the economy.

However the honest taxpayers need not to worry. Even if you have Rs 10 lakhs as cash with you and you can prove its legitimacy, you don’t need to worry. The surprise move by government is a disaster for people who have accumulated lakhs and crore of unaccounted cash under their pillows and mattresses. The winter is coming and these worthless pieces of paper can provide the corrupt some ephemeral warmth.

The timing of this announcement seems obvious, in hindsight. With the massive rollout of the Pradhan Mantri Jan-Dhan Yojana (PMJDY) in India, citizens’ access to bank accounts is nearly complete. A demonetization move would have been impossible if low-income households were unbanked. PMJDY has provided them with free bank accounts, which will also be used to transfer government payments. The need for honest people to stash cash in mattresses, therefore, has diminished. This move by the PM has also followed the income disclosure scheme where people were given a window of opportunity to declare their wealth amassed through various means. It was an appropriate time, therefore, to make credible the threat of a crackdown on black money and corruption within India.

Of course, actually implementing this is something of a mammoth task. Modi explained how the country is planning to carry out this massive operation over the next few months, as millions of Indians will attempt to exchange their old notes. It will stretch the capabilities of the financial system, which already does not extend across the country, and the interim period will also see many attempts by those holding on to black money to turn their cash into legal tender. The effort also depends heavily on Indian authorities actually delivering on the promise to make it easy for people to turn their old currency into smaller denominations. After this, the government plans to reintroduce a new Rs 500-denomination note, with limited circulation.

The biggest sufferers would be unorganized and informal sector as they predominantly deal with cash. Other loser would be mid-cap and small- cap companies which collect and make payments in cash. This pain will continue till this stock of cash is replenished by the banking system, which can be a quarter or two.

On inflation, the price level is expected to be lowered due to moderation from the demand side, according to CARE Ratings research paper. Some economists say that lower money supply would lead to deflationary pressure with too little money chasing too many goods. However, on the contrary, some economists believe that the move might work the other way round and help curb inflation with lower money supply as unaccounted money would be taken out of the system. In the long run, this is a significant positive shock to the Indian economy and society. If substantially implemented, this will send a strong signal about India’s anti-corruption drive and is very likely to improve the country’s reformist stance.

In spite of the initial hiccups and disruptions in the system, eventually this change will be assimilated in the system and is to eventually prove positive for the economy in the long run. Whether this would eventually boost economic activity that is remains to be seen. But, orders of magnitude are very difficult to establish and hence, any claim of such improvement in formal economic activity with consequent beneficial tax impacts and other social economic multipliers must be deemed wholly speculative at this stage. This move by the government along with the implementation of the GST will eventually make the system more accountable and efficient.

 

This article was written by Varnita Deep (PGDM, Batch 22, XIME-B

Should the RBI be Independent?

The debate arises because of the new Monetary Policy Committee. It points us towards two important aspects of any central bank – Independence and accountability. So how do we resolve all these two objectives and make sure that the Central Bank is capable of tackling the issues that it faces meeting the objectives that it is supposed to meet while at the same time remaining accountable to the people.

 

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What are the major functions of RBI?

 

  • Regulating the economy or regulating other players in the economic system.
  • RBI acts as a monetary authority in India.

 

This in turn means that RBI is a complete authority as far as Monetary Policy is concerned. It not only makes the rules, not only implements them but also monitors them. Whereas if we think in terms of the political structure of India ,formulation is done by legislature, implementation is done by the executive and monitoring is done by the judiciary, whereas here RBI is doing all three functions.

 

What is the objective of Monetary Policy itself?

 

  • Maintaining price stability
  • Ensuring adequate flow of money
  • Credit to required areas.
  • It acts as a regulator and supervisor of financial system

 

This is what RBI tries to achieve through its Monetary Policy. Maintaining the overall stable level primarily through controlling the interest rates and all this is done so as to maintain public confidence in the system. So, RBI puts some rules to the banks to follow so that banks maintain the trust of the public. It manages the FEMA, Foreign Exchange Management Act, so as to facilitate foreign trade to develop Indian trade as well as to maintain rupee stability in the foreign exchange market as well. RBI is also the issuer of currency because it is controlling the money supply in the country, so it issues currency and also destroys currency. Specific to a developing country RBI also has a development role in which it tries to promote what the Government is trying to do with the development agenda. It also has some major banking functions such as being a banker to the Government, being a banker to other banks and even being a lender of last resort in the economy.

 

What are the goals of the RBI?

 

RBI governor also consults with important bodies like FICCI CRISIL etc. so as to get a good understanding of the sentiments in the business sector of the country. In addition to all this RBI also publishes the annual report on the official website for public discussion and for transparency. So a good amount of transparency is being maintained in the current system itself. Now this structure of the RBI makes it one of the most independent agencies of the Government. It is comparable to Supreme Court in terms of independence that it commands. However RBI governor is appointed by the Government of India so that is one notch below in terms of independence. It is also one of the most independent Central banks in the entire world.

Now there are two different viewpoints about the RBI. One is that RBI has too much power and should be controlled more by democratically elected Government. So one viewpoint is we have to control RBI’s power so that democratically elected Government has power over RBI, or power over the Monetary Policy making. Another viewpoint is RBI should remain independence or else politicians including the Parliament and the Prime Minister’s office could order the RBI to boost money supply, increase credit etc. just before an election.  Government could misuse Monetary Policy for its own purposes because of that RBI has to remain as a separate institution. That is another viewpoint.

So what is the case for Central Bank independence? The first is that RBI avoids inflationary spending by the government. The government might spend more to meet its own political agenda, such as, spending more before an election so that people have a perception that the country is improving etc. So government can sell this by forcing the banks to buy bonds so that the government can spend more. This is banned because this can lead to inflation very fast. So one reason an independent organization is good is that this kind of problems can be avoided. And we can avoid the use of Monetary Policy for political goals.

So we cannot lower interest rates before an election so as to win an election. We can only lower the interest rates when we feel that the inflation is low enough to allow that. Otherwise, the election will in turn cause inflation. The election cycle used to be matching with the inflation cycle but independent RBI can control this kind of mismatches. If the government is given power over Monetary Policy, governments have a tendency, automatic tendency to misuse that power.

 

What is the case against central bank independence? 

 

The biggest reason is that central bank is not directly accountable to the voters. What the voters want and what the bank does might be slightly at odds. So RBI might sometimes be implementing monetary policy against the wishes of the electorate. For example, there could be a stack inflation situation in which economy is not growing. At the same time unemployment is high as well and RBI cannot reduce interest rates. Instead it has to hike interest rate because inflation is high. Now the electorate might not appreciate that. People might start feeling why should the RBI have this power, why can’t we decide, why can’t our government decide? So those kind of questions can come. Also government might sometime blame RBI for not allowing India to develop etc. So in these situations this accountability issue becomes a problem.

 

This article was written by Paulami Paul (PGDM, Batch 22, XIME-B)