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)

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

The Rajan Effect

Raghuram Rajan Takes Charge As Governor of The Reserve Bank of India
(Source: JapanTimes)

 

It’s time to bid a bittersweet adieu to Rajan. On the 4th of September, Raghuram Rajan, the current RBI Governor, will have completed three years in office. In these years, Rajan has garnered immense popularity as a central banker, especially for his determination and strict policies of fighting inflation. He gained nicknames such as ‘R3’ and ‘Rockstar’ as a part of his massive fan-following. The media made a highlighted his every public move, even comparing him with the likes of James Bond, for his famous words “My name is Rajan. I do what I do.” All in all, Rajan was a new kind of Central Banker to India that his predecessors never were – the famous kind.

A IIT-D and an IIM-A Gold Medalist, Rajan is also a distinguished University of Chicago scholar. Before his stint at the RBI, he served as the Chief Economist of the International Monetary Fund. Rajan is best known for anticipating the 2008 subprime lending crisis in his paper, “Has Financial Development Made The Word Riskier?” He also reiterated his views in the post-crisis short film “Inside Job“.

 

 

His record at the Reserve Bank of India speaks for itself. Raghuram Rajan walked into Mint Street in September 2013 while a currency crisis was unfolding. The rupee was nose diving and had almost hit Rs. 69 to a dollar while currency reserves had hit a three-year low. Inflation was galloping as well and at that time looked far beyond anyone’s control. While Consumer Price Inflation had hit 9.84 per cent in September 2013, inflation in primary food articles had crossed the 18 per cent mark.

On day one as central bank chief, Rajan vowed to preserve the value of the currency. He waged a war against inflation and straightened the rupee in weeks. To calm the vulnerable rupee, Rajan launched the FCNR (B) (Foreign Currency Non Resident (Bank) account is an account that can be opened with an Indian bank by a Non Resident Indian or a Person of Indian Origin in foreign currency) scheme under which it offered discounted currency swaps to banks to spur inflow.

 Banks raised $25 billion through FCNR deposits and another $9 billion through foreign currency borrowings. Surprising many, Rajan hiked Repo Rate not once but twice in October 2013 and January 2014 to break the spiral of rising inflation. The Indian economy has seen significant changes over the three years that Raghuram Rajan has been the Governor of the Reserve Bank of India.

In September 2013, when Rajan took over, the economy was part of the infamous ‘Fragile Five’ grouping. Today, it is celebrated as the fastest growing major economy in the world.While fortuitous factors like a drop in commodity prices have helped steady the fundamentals of the Indian economy, so have sound macroeconomic policies like a focus on bringing down inflation, building foreign exchange reserves and allowing a steady increase in foreign participation in the Indian debt markets.

 

Here is a summary of how economic indicators have evolved during Raghuram Rajan’s tenure as the Reserve Bank of India Governor:

 

  • Rupee: To say that the rupee was in bad shape will be an understatement. Two months before Rajan took office, the domestic currency had depreciated by a staggering 10.4 per cent as India faced its worst currency crisis in recent memory. Ever since Rajan took over, the rupee has gained 1.12 per cent with implied volatility hitting an eight-year low last week

 

  • Lending rate: Lending rate, or the rate of interest banks charge from borrowers, stood at 10.3 in September of 2013. As of August 2016, it’s down by 90 bps at 9.3 per cent. High lending rate has been one of the key concerns in the second half of Rajan’s tenure, as repeated cuts in repo rate by the central bank didn’t get transmitted fully.

 

  • Inflation: Rajan is known for his primary focus on curbing inflation. His biggest achievement is that he successfully brought down retail inflation to 3.78% in July 2015 from 9.8% in September 2013 – the lowest since the 1990s. Wholesale inflation was down to a historic low of -4.05% in July 2015 from 6.1% in September 2013. Under Rajan, the RBI adopted consumer price index (CPI) as the key indicator of inflation, which is the global norm, despite the government recommending otherwise.

 

  • Equity: In his first speech as RBI governor, Rajan promised banking reforms and eased curbs on foreign banking, following which Sensex rose by 333 points or 1.83%. After his first day at office, the rupee rose 2.1% against the dollar. The equity market, although not directly under Rajan’s influence, has nonetheless had a blast during Rajan’s tenure. The BSE Sensex rose 51 per cent even since Rajan took office through August 8, 2016. The NSE Nifty50 has gained 60 per cent in the same period.

 

  • Gross NPAs:The biggest achievement of Rajan’s tenure may not look like an achievement at all. Gross non-performing assets at India’s scheduled commercial banks jumped three-fold from Rs 2,52,275 crore in December 2013 to Rs 5,94,929 crore by March, 2016, thanks to a clean-up of the banking system that has brought forth the ugly side of the banking sector. With a former RBI governor accepting the responsibility for not doing much about the issue, the burden fell on Rajan and his team.

 

  • Foreign Exchange : Perhaps, a hands-down winner during Rajan’s tenure, foreign exchange reserves of RBI have swelled to record high. From $275 billion in September of 2013, it now stands at a record $365 billion and will provide the arsenal to the central bank to brace for the FCNR bond redemptions coming up in September, which is likely to create some ripples in the currency market. India’s forex reserve is now stronger by about 30% than it was two years back.

 

  • Banking: Under Rajan, two universal banks have been licensed and eleven payment banks have been given the nod. This is expected to extend banking services to the nearly two-thirds of the population who are still deprived of banking facilities.

 

  • Interest rates:After initially raising nominal interest rates by 50 basis points, or 0.50 per cent, to quell inflation, RBI embarked on a journey of rate cutting which is now in its 18th month. When Rajan took office, repo rate stood at 7.5 per cent, which then rose to 8 per cent in January 2014. Post-January 2015, repo rate has been slashed by 1.5 per cent to 6.5 per cent, which is the lowest level in four-and-a-half years.

 

  • Current account deficit:The current account deficit, though essentially a finance ministry domain, has seen a marked improvement over the past three years, climbing down from a record high level of 4.10 per cent to 0.1 per cent in June 2016.

 

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(Source: ETMarkets)

 

 Rajan’s early focus and battle with inflation earned him nicknames ranging from ‘Inflation warrior’ to ‘Inflation Hawk‘. There are a number of points to consider here when viewing the criticisms against Rajan’s stance on inflation and interest rates. He has more aggressively expanded on his predecessor’s attempt at using interest rates to curb inflation. The arguments in favour of Rajan having erred, when it comes to interest rates and inflation, are three-fold.

First, the central idea that the high inflation in the Indian economy was due to excess domestic demand is flawed. This inflation can be more attributed to global excess demand and thus raising interest rates was flawed. If this is true, Rajan’s restrictive monetary policy has been completely off the mark.

Second, even if Rajan’s initial stance of keeping inflation as the RBI’s number one goal was correct, he may have been too late in recognizing when this goal was achieved and therefore late in eventually cutting interest rates. Rajan at the time was still hesitant to cut interest rates even though retail inflation had fallen to 3.8%.

The problem of different perspectives here – whether India was undergoing disinflation or deflation – stemmed from the RBI’s decision to look at retail inflation (CPI) while deciding its monetary policy. So while the wholesale price index sat at negative 4% at that point of time, CPI was still at 3.8%.

The last argument for Rajan having tripped up was that even after he started his rate cut cycle, he didn’t do enough to help the money markets that were gasping for liquidity; a crucial side-effect of this was that a free transmission of rate cuts did not happen. It was only in his last year, and more specifically in the last five months, that the RBI governor set out to make more cash available in the banking system.

Out of these three arguments, there is greater evidence and support for the last two. In some ways it’s a pity that criticism levied against Rajan comes from parties that had a vested interest in his policies: politicians, India Inc. lobby groups, debt-laden promoters and wilful defaulters.

In his farewell letter, Rajan expresses a tinge of disappointment that he will not be able to see through two important developments: The formation of a monetary policy committee that may eventually reduce the role of the RBI governor, The asset quality review of public-sector banks.

Apart from these two issues, however, what has received less media attention was Rajan’s aim of overhauling the RBI’s administrative structure, including hiring talented external employees as well as improving the quality of institutional research.

One big mistake Rajan did was he failed to fathom the tolerance level of ruling political dispensation to criticism, especially on political matters. In a country, where all government bureaucrats are supposed to toe the line of their employer, no government servant, even if he is the RBI Governor, is supposed to speak his mind on sensitive political issues. That’s a taboo. The moment Rajan stepped out of his mandate and started commenting on political issues, the discord between him and the government started.

Rajan’s work is nothing short of exceptional. However, newer Central Bankers will most likely match his performance and maybe even exceed it. But whether India will have such an honest, outspoken and fearless Central Banker is a huge question mark. Rajan himself has assured that he remains loyal to India and will be happy to serve the people whenever he is called upon again. At this moment, we can only be thankful for his contributions and restate the message of the RBI Staff in their tribute rangoli to their outgoing boss: “Alvida na kehna” (“Never Say Goodbye“).

 

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