Market participants have said that the huge borrowing programme announced by the government in the Union Budget may prompt the central bank to hike the reverse repo rate. The government announced a gross borrowing of Rs 14.1 trillion for the next financial year.
State Bank of India (SBI) Research Report stated that the Reserve Bank of India (RBI) is likely to hike the repo rate by 20 bps outside MPC. The report titled ‘20 bps hike in reverse repo rate outside MPC’ is authored by Dr Soumya Kanti Ghosh, Group Chief Economic Adviser, State Bank of India. “Given all this, we believe the time is now appropriate to go for a 20 bps hike on reverse repo rate, but outside the MPC meeting as enshrined in the RBI act that lays down that reverse repo is more of liquidity management. A hike in the reverse repo is also required as a larger corridor has resulted in rate volatility.” the report said.
Let us understand why the RBI may go for a hike in the reverse repo rate and not the repo rate. The RBI adopted an ultra-loose monetary policy after the pandemic broke out. In order to inject liquidity into the system to spur growth, it slashed the repo rate to a record low of 4%. The rate has been held at that level since May 2020.
Repo rate is the rate the RBI charges when it lends money to banks for the short term. A cut in the repo rate results in commercial banks lowering interest rates, in turn encouraging businesses to borrow at low rates. At the same time, what depositors receive on their savings and fixed deposits would also fall. This is meant to motivate the public to increase consumption.
Meanwhile, the reverse repo rate is the rate that the RBI pays banks when they park their excess liquidity with it. The rate has remained unchanged at 3.35% since May 2020 after a sharp reduction of 155 basis points that year.
The lower reverse repo rate acts as a disincentive for banks to keep their surplus money with RBI, pushing them to give out loans. During normal times, the gap between the two key rates, which is also known as the policy corridor, is 25 basis points. This gap was widened by the central bank to 65 basis points after the onset of the COVID-19 pandemic.
The RBI is widely expected to start policy rate normalization and bring down the gap back to 25 basis points. It is looking to absorb the excess liquidity in the market as concerns over the Omicron variant wane. India’s daily COVID-19 cases have fallen from a high of 3.48 lakh on January 21 to 1.49 lakh on Friday.
The move will also rein in inflationary pressures in the economy. Retail inflation, which is the yardstick for the RBI policy-making, hit a five-month high of 5.59% in December. The central bank has a target of 4% inflation, with a variation of 2% on both sides.
Global cues will also influence RBI’s decisions. The Bank of England on Thursday raised interest rates by 0.25 percentage points to 0.5% to contain spiralling inflation while the US Federal Reserve signalled a first rate hike in March.
Most analysts expect the RBI to hike the reverse repo rate by as much as 40 bps on Wednesday before starting to raise the repo rate from April. RBI’s normalization drive will, however, lead to higher interest rates in the economy. Banks will pass on any hike in repo rate by increasing interest rates on loans.
On the back of RBI’s accommodative monetary policy, home loan rates had fallen to multi-year lows in the past two years with some leading lenders offering home loans starting at 6.75. As most home loan rates are linked to the repo rate, they will see an uptick as the RBI benchmark rate is hiked.
Following the Union Budget, the yield on the 10-year government bond jumped to 6.92%. This means the government is borrowing at a higher cost compared to some buyers. And this situation is not expected to last long.
