In every country there is a central bank or reserve bank or monetary authority, which is a public institution and is responsible for issuing the currency, managing interest rated in that country as well as overseeing commercial banking system. For e.g. in Singapore it’s called as Monetary Authority of Singapore (MAS), in India it’s called as Reserve Bank of India (RBI), in USA it’s called as Federal Reserve Board. The banking structure for central bank is strikingly different in USA than most of the commonwealth countries however I will not discuss this in this article.
Often you might have heard that the RBI has increased the short-term indicative policy rate (repo rate) by 25 or 50 basis point to curb inflation…..so what is this repo rate ? CRR? and how is inflation related to repo rate?
Repo Rate: Repo or Repurchase agreement is an agreement between the RBI or central bank and generally commercial banks (..but not necessarily limited only to commercial banks). To understand what is repo rate is we need to have some understanding on what is CRR (Cash Credit Ratio) and what is SLR (Statutory Liquidity Ratio). As I mentioned earlier, one of the important function of the central banks is to oversee the commercial banking activity and set guiding rules for commercial banking environment.
What is SLR? - Central bank insists that significant part of the bank’s assets should be kept in liquid form either with banks themselves or with central bank. Statutory Liquidity Ratio (SLR - Currently 24 % in India) is ratio of liquidity to total assets for commercial banks. If you have heard of the term “bank run” then you would understand why this SLR obligation is in place for commercial banks.
What is CRR? – Central bank also insists that certain part of their deposits to be “parked physically with the central bank” in form of liquid assets such as cash, TB or G-Sec. The CRR basically represents how much liquid assets should commercial bank has to deposit with central bank (CRR - Currently 6% in India i.e. 6% of liquid assets has to be kept physically with central bank) in proportion with the amount of deposits (time deposit, fixed deposit, savings deposits, current accounts etc ). CRR obligations got be met else there would be heavy penalty and it is done on weekly basis in India (every Friday). Let’s see CRR from two perspectives 1) If the amount of deposits for a commercial bank rose by Rs100 and if the CRR is 6%, then it means extra Rs 6 has to be put with RBI in terms of liquid assets along with existing liquid assets that was held at RBI earlier. 2) Other way to look at it is if the CRR is increased that means the central bank is asking the commercial banks to put more liquid assets with them and hence central bank is reducing the money supply in the market, on the other hand if the CRR is reduced then central bank wants to increase money supply in market.
CRR is leading rate because central banks move CRR up or down by asking commercial banks to keep less or more liquid assets with them (central bank). As 25 basis point change in the CRR rate can contract money supply by thousands of billions of Rs or even more in India today.
Due to this obligation of CRR, there is new money market called as interbank market where banks lend to each other to achieve the CRR requirements posed by central bank. The rate at which commercial banks lend to each other is called as SIBOR in Singapore and in India it is called as MIBOR (Mumbai Interbank Offered Rate). If recession kicks in then you will observe that this rate would go quite high and in worst cases the commercial banks in good financial conditions will stop lending to the other commercial banks which are not in good financial conditions. This will create credit crunch in banking system.
What is bank rate? – In most commonwealth countries Central bank is considered as last lending resort for commercial banks; however, in USA it is a common practice for the commercial banks to borrow money from Federal Reserve banks (called as Federal Fund Rate). The commercial banks rarely go to central banks to get the money from reserve bank. Bank Rate (Currently 6 % in India) is the interest rate RBI charges on advances to commercial banks. Banks borrow from RBI as Lender of the last resort.
In USA, in routine course of business the Central bank buys or sells TB or G-Secs in the market. Every time FRB buys something it pushes money into the market (cash outflow to market). For e.g. US Fed has pumped over 3TUSD in the market. Federal Reserve Board in US uses this as a weapon to manipulate the money supply almost all the time.
However in most of the commonwealth countries central bank uses G-secs for borrowing and lending i.e. buying with promise to resell at same price or vice-versa from commercial banks. When central bank sells with promise to buy back within a stipulated period (generally 90 days to 1 year), central bank is drawing (mopping) money from the country i.e. it is compressing liquid assets of commercial banks and is reducing overall money supply in the market. Remember buying and selling prices are same. This transaction is called as “Repo Transaction”. The interest rates are called as repo rate (the rate at which commercial banks borrow from the central bank) and reverse repo (the rate at which commercial banks park their funds with the central bank). With Repo transaction money supply is increased and through reverse repo transaction the money supply is decreased. When repo rate is adjusted, generally reverse repo rate is also adjusted. Whether commercial banks would get involved into such repo transaction is up to them however, if commercial bank has intention to expand the lending then the banks would need extra short term money to meet CRR obligations and in such cases repo transactions are easy money option for the commercial banks and hence all commercial banks will use this option.
Beside quantitative impact of CRR and Repo Rate the Central bank uses these interest rate as a mechanism to signal to the bankers/market. When central bank wants to reduce money supply the central bank will increase the rate and indicate the market that they had gone way too ahead and expanded too much of money supply i.e. too many loans were given, reduce them! Other major usage of CRR and Repo Rate increase is to curb inflation. If the CRR, repo rate were increased by few basis point then the money is taken out of the system automatically. To understand this lets see the below example.
Let me take example of China or India. In China, as the exports are higher than imports, China has a huge surplus of USD because USD is the global currency and all international payments are done in USD. This is very visible by the fact that the China is holding 3 TUSD reserves at the moment. As this excess USD is coming into China and if there is no increase in demand for the USD; automatically, the Yuan would start appreciating against USD (supply/demand equation). Any appreciating currency works against the exports and vice-versa for a country. To tackle this problem, central bank of China will buy those USD and supply Yuan into the local market i.e. the money supply would increase in market. More the money supply, higher the prices would be, which will lead to inflation. Now, to curb this inflation central bank of China will have to increase the CRR, repo rate to mop or take the excess money out of the market. Similarly, in India if Rs starts appreciating against USD then all exporters in India would start begging RBI or government to intervene as appreciating Rs it will work against them. The excess USD coming into systems are converted into Rs into local market and then again taken out from the market by increasing CRR, repo rate. This is how SLR, CRR, repo rate, reverse repo rate, bank rate and inflation are related.
