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The great Indian repo trick

Tamal Bandyopadhyay | April 24, 2003

Will Reserve Bank of India governor Bimal Jalan cut the benchmark bank rate next week when he announces the monetary and credit policy for fiscal 2003-04?

Eight out of ten bankers say yes. There are, however, differences of opinion on the depth of the cut. Some feel it could be as much as 50 basis points (one basis point is one hundredth of a per cent) to bring it down to 5.75 per cent from 6.25 per cent; others suggest a 25 basis points cut to 6 per cent.

What about a cut in the cash reserve ratio? Again, an overwhelming majority -- seven out of ten bankers -- say yes.

Will Jalan cut the repurchase (repo) rate as well? Only one adventurous soul of the ten ventures a "yes".

Actually, the "yes-man" has probably read the situation accurately. If Jalan -- now a veteran of ten credit policies -- is realistic, this is precisely what he should do.

The reason: it's the repo rate -- or the rate at which the central bank borrows money to suck out short-term liquidity from the system -- that is emerging as an important signal for bankers to adjust interest rates.

Of course, this will mean dealing with the financial sector's collective obsession for a cut in the bank rate. Even if Jalan were to comply, the gesture would be a pointless one for the simple reason that the bank rate is losing its relevance as a signalling device.

Indeed, there have been occasions when bankers refused to cut their prime lending rates in response to a bank rate cut. It is another matter that as a concept PLR too is losing its relevance with most borrowers raising bank loans at below PLR.

Lending rates now depend on the cost of funds, not the bank rate. The cost of funds is decided by market forces which, to a large extent, are guided by the short-term repo rate.

Here's why. Ever since the bank rate was reactivated in April 1997 by former Governor C Rangarajan as the most powerful indirect tool of monetary control, the central bank's monetary policy has rested on the tripod of the CRR, repo rate and bank rate.

Jalan took over as RBI governor in November 1997 and since then, the central bank has cut the bank rate from 11 per cent (in January 1998) to 6.25 per cent through two increases and nine cuts. The CRR was dropped from 9.5 per cent on November 22, 1997, to the current 4.75 per cent.

This was initiated through 14 cuts and six hikes in the CRR. And the repo rate -- introduced in mid-2000 -- has fallen from 7 per cent in July 2000 to 5 per cent through seven increases hikes and 23 cuts.

What has changed now is the surplus liquidity in the banking system, which is making the repo rate gain more relevance than the bank rate.

Theoretically, the bank rate is the rate at which the central bank offers refinance to the commercial banks. The dormant bank rate received a fresh lease of life six years back in 1997 when Rangarajan revived it and linked it to a Rs 4,600-crore (Rs 46 billion) general refinance kitty.

The bank rate was raised to 11 per cent in July 1991 and further to 12 per cent in October 1991 against the backdrop of high inflation and a difficult balance of payments. The rate stood at that level for nearly six years despite changes in various economic parameters.

Till 1997, the bank rate had little operational significance since the refinance rate was fixed at a lower level. Rangarajan felt it was necessary to make the bank rate an effective signal rate as well as a refinance rate.

So he brought down the bank rate to the level of the export refinance rate since the latter was blunting the efficacy of the signal rate.

Ideally, when the central bank moves the bank rate, like the discount rate in the US, all rates in the economy should move in tandem. Bankers expect a rate cut to signal a general downward trend in interest rates which was flagged off by Finance Minister Jaswant Singh in the Union Budget.

But the point to note is that it was the repo rate that the RBI cut (along with the savings bank rate) hours after the Budget was presented on February 28.

Even though the repo is a short-term instrument, this is emerging as the new anchor for the market because the yield curve of  government securities or gilts is also being built on this rate. In the gilts market, in fact, it is the short-term rates that are influencing long-term rates instead of the other way round.

For instance, the repo rate -- which is effectively a one-day rate -- is pegged at 5 per cent. The overnight interbank call rate is slightly lower than the repo rate and the 91-day and 364-day treasury bill yields are around 15 to 20 basis points over the repo rate.

Extending the spread, the five-year paper yield is around 60 basis points over the repo rate and the 10-year paper yield 85 to 90 basis points higher at 5.85 to 5.90 per cent.

In other words, even though the repo is a short-term rate, it is influencing the entire interest rate structure in the market. This is bound to happen in a liquidity surplus system where nobody borrows at the bank rate and everybody wants to lend at the repo rate.

In effect, in such a situation it is the rate at which the RBI borrows from the market that becomes the anchor and not the rate at which commercial banks borrow from the RBI.

On an average, over the past fortnight, banks have been putting around Rs 25,000 crore (Rs 250 billion) at the RBI's repo window every day. No wonder that the repo is calling the shots and the bank rate has become impotent.

In fact, the central bank is the best borrower in town today offering 5 per cent for the repo rate. Even the inter-bank rates (where one bank borrows overnight money from another bank to meet temporary asset-liability mismatches) have fallen below the repo rate.

In normal circumstances, the repo rate should act as the floor for the call rates. But these are abnormal times when the RBI is lapping up every dollar from the forex market and the money used for the dollar purchase is adding to the deluge of rupee liquidity.

Whether the RBI admits it or not, the repo is the new anchor for the financial system. Its sanctity can be preserved only if it is cut to a realistic level (around 4.5 per cent or so). The bank rate and CRR cut can, at best, complement it.

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