Repo Rate, RBI, & Indian Economy
WWI came to an end, Germany’s Weimar Republic was made to pay the reparations of war. Germany’s economy collapsed. The Weimar Republic opted for the solution which seemed the easiest. The Weimar Republic printed an excess of notes, completely killing the value and credibility of the currency. Common people were short for plain white paper or newspaper, but had currency notes worth 20,000,000, to 5,000,000,000 denominations.
The case highlights the importance of monetary policy which manages liquidity and limits inflation (Inflation means general increase in the price of goods). For similar reasons India constituted Reserve Bank of India Act 1934, whose Chapter II Article 3 says, “A bank to be called the Reserve Bank of India(RBI) shall be constituted for the purposes of taking over the management of the currency from the [Central Government] and of carrying on the business of banking in accordance with the provisions of this Act.”
There are two most important responsibilities of the RBI, one to maintain the inflation at 4%, + or – 2%. Second is to facilitate growth. The most effective tool the RBI has to carry both responsibilities is repo rate. This article aimed to get a glance about the use of repo rate and current conditions of the repo.
Repo rate is a quantitative instrument which affects the supply of liquidity in an economy. In simple words, repo rate is the rate at which the central bank of a country lends money to commercial banks which commercial banks will lend in the form of loans charging higher interest rates.
Repo rate can boost the growth and also reduce inflation in adverse conditions. For instance if RBI targets to facilitate growth, it will be driven by the demand in the economy. A household will demand when sufficient purchasing power is available. If the household has money in pockets ultimately benefiting industries and completing the circular flow of income.
So when the RBI wants demand to grow, RBI reduces repo.
In response to reduced repo rate, commercial banks borrow more money from the RBI. It further leads to reduction in the rate of interest which is charged by the banks over the loans given to the households. These households apply for loans and purchasing power rises, creating demand. Goods are being produced, consumed, produced … until a point where the household still demands but supply falls short. This rising demand leads to price rise. This is inflation, where more money runs behind a few goods.
If the Consumer Price Index (CPI Inflation- index which helps RBI to know the Inflation rates) is high, RBI notes that the currency in the economy is in more than the supply of goods. RBI needs to adjust the supply of currency with respect to supply or else hyper-inflation could prevail. Hence the RBI raises the repo.
Now, commercial banks do not draw currency from the RBI. The RBI window for borrowing money is closed, but commercial banks need money to re-circulate it in the form of a loan to earn interest (which is profit for banks).
To pool money, commercial banks raise the interest rates on the deposit (i.e. savings accounts, F.D. etc). So cash in households gets deposited in the bank which forms the liquidity quotient of the banks. The RBI has a reaction where the money/liquid from the pockets of households is sucked, reducing the demand. Once demand is lowered, inflationary prices come back to normal. If this further continues, households continue depositing money, demand could be destroyed bringing an economic slowdown, where goods are produced, but no one to consume. To surpass this RBI again cuts repo injecting liquid in the economy maintaining demand.
In February 2022 i.e. 4th Quarter of FY 2021-22, the Monetary Policy Committee (MPC) met to decide on the repo rate for the upcoming financial quarter.
Per the discussion of the MPC, the GDP growth rate as per National Statistical Office (NSO) was 9.2% for 2021-22. With the rapid spread of Covid and Omicron variants, global economic activities dampened, coupled with price rise and weakening of demand, resulting in stagnation of the wheel of economy. Accordingly, the MPC judged that domestic recovery after a pandemic shock is still incomplete and needs policy support of sufficient liquidity. Suitably the MPC decided to keep the policy repo rate unchanged (low) at 4% and to continue with an accommodative stance to sustain growth.
The next meet took place in April 2022. Talking precisely about the April meeting, the MPC noted that global economic financial conditions have worsened with escalations of geo-political conflict. Crude oil prices jumped over 14 year high in early March. Urban demand which is reflected by domestic air traffic has picked up in March. But rural demand mirrored in two-wheeler sales and tractor sales shrunk in February. Inflation projections moving as high as 7.5 percent in Q1 FY 2022-23 as an effect of war.
In response to the rising inflationary pressures in the advanced countries, they have begun to increase policy rates and to tighten liquidity conditions. This tightening with a raise in the repo rate is expected to continue to bring down the inflation rates, impacting emerging market economies.
Inflation is so widespread that Dr. Michael Patra, deputy governor in charge of monetary policy said, “In a world in which deglobalisation seems imminent, one thing has become globalised and that is the alarm about inflation. With 60% of developed countries facing inflation above 5% – unheard of since the 1980s – and more than half of developing countries experiencing inflation above 7 per cent, the climb in prices is testing societal tolerance levels.”
Comments were cautious but the domestic economy needed the support of liquidity, due to which the MPC unanimously decided to keep the rate unchanged at 4 percent.
There was an off-time meeting of the MPC called in May for urgent corrective measures, under which the repo rate was increased by 40 basis points, making the rate 4.40 percent. This tightening in rate was due to inflationary pressure emanating from the external developments – Russia-Ukraine war leading to supply disruptions. The MPC noted that there is rarely anything the MPC can do about the rise in inflation since the problem is not an increase in demand but it is constraints from the supply side, that too on an international level. So compressing demand is the only way forward to sustain balance. Consequently, the repo was raised.
The latest MPC meeting was held in June, where the resolution was to raise the policy repo rate by 50 basis points, further tightening it making it 4.90%. Dr. Michael Patra, in his comments said that, if this inflation is allowed to go out of hand, it could
- Corrode recovery – empirical evidence shows that inflation above 6 per cent in India is harmful for growth;
- Deter investment decisions(FDI, FII) because businesses will worry about demand for their products,
- Cause exchange rate depreciation which will increase imported inflation, trigger large capital outflows depreciating rupee in currency markets.
The repo rate is an effective tool in the toolkit of RBI to maintain a fine balance between demand and supply and calibrate economic conditions skillfully to avoid any cracks in the economy and currency of India. There are many more tools like CRR, SLR rates, OMO, etc. The MPC discusses a whole lot of issues concerning food and fuel prices, rain conditions, foreign exchange reserves, imports and export conditions but all the points are reflected in a single number i.e. repo rate.
*The views/opinions expressed in the above article exclusively belong to the writer. Tatvita may have different opinions on the subject.*
- Reserve Bank Of India act, 1934. (As modified up to February 28, 2009)
- Monetary Policy Committee meeting, 2 & 4 May 2022
Aayush Patil is a Research Intern at Tatvita. Presently he is pursuing his bachelors in the Liberal Arts department at the Savitribai Phule Pune University.