Context

• The Indian economy’s slowdown during 2018 and 2019 is becoming much worse in 2020 with the spread of COVID-19 and the stalling of almost all economic activity.
• Like most other central banks in the world, the RBI, too, has tried to cut interest rates to boost the economy.
• However, unlike in the past, when the RBI used its repo rate as the main instrument to tweak the interest rates, today, it is the reverse repo rate that is effectively setting the benchmark.

We can expect a straight forward question based on this newscard.  For example:  “Critically examine the efficacy of reverse repo rate as benchmark interest rate in the Indian economy. “

What are repo and reverse repo rates?

• The repo rate is the rate at which the RBI lends money to the banking system (or banks) for short durations.
• The reverse repo rate is the rate at which banks can park their money with the RBI.
• With both kinds of the repo, which is short for repurchase agreement, transactions happen via bonds — one party sells bonds to the other with the promise to buy them back (or repurchase them) at a later specified date.
• In a growing economy, commercial banks need funds to lend to businesses.
• One source of funds for such lending is the money they receive from common people who maintain savings deposits with the banks. Repo is another option.

Repo as benchmark

• Under normal circumstances, that is when the economy is growing; the repo rate is the benchmark interest rate in the economy.
• This is because it is the lowest rate of interest at which funds can be borrowed and, as such, it forms the floor rate for all other interest rates in the economy.
• For instance, the interest rate consumers would have to pay on a car loan or the interest rate they will earn from a fixed deposit etc.

What has changed now?

• Over the last couple of years, India’s economic growth has decelerated sharply.
• This has happened for a variety of reasons and has essentially manifested in lower consumer demand.
• In response, businesses held back from making fresh investments and, as such, do not ask for as many new loans.
• Add to this, the pre-existing incidence of high non-performing assets (NPAs) within the banking system.
• Thus, the banks’ demand for fresh funds from the RBI has also diminished. This whole cycle has acutely intensified with the ongoing lockdown.

Consequences: Rise in Liquidity

• As such, the banking system is now flush with liquidity for two broad reasons.
• On the one hand, the RBI is cutting repo rates and other policy variables like the Cash Reserve Ratio to release additional and cheaper funds into the banking system so that banks could lend.
• On the other, banks are not lending to businesses, partly because banks are too risk-averse to lend and partly because the overall demand from the businesses has also come down.

So, how has reverse repo become the benchmark rate?

• The excess liquidity in the banking system has meant that banks have been using only the reverse repo (to park funds with the RBI) instead of the repo (to borrow funds).
• As of April 15, RBI had close to Rs 7 lakh crore of banks’ money parked with it.
• In other words, the reverse repo rate has become the most influential rate in the economy.

What has the RBI done?

• Recognising this, the RBI has cut the reverse repo rate more than the repo (see graph) twice in the spate of the last three weeks.
• The idea is to make it less attractive for banks to do nothing with their funds because their doing so hurts the economy and starves the businesses that genuinely need funds.

Will the move to cut reverse repo, work?

• It all depends on the revival of consumer demand in India.
• If the disruptions induced by the outbreak of novel coronavirus continue for a long time, consumer demand, which was already quite weak, is likely to stay muted.
• Businesses, in turn, would feel no need to borrow heavily to make fresh investments.
• If consumer demand revives quickly, the demand for credit will build up as well.

Concerns of lower reverse repo

• From the banks’ perspective, it is also important for them to be confident about new loans not turning into NPAs, and adding to their already high levels of bad loans.
• Until banks feel confident about the prospects of an economic turnaround, cuts in reverse repo rates may have little impact.

Back2Basics: Long Term Repo Operations (LTRO)

• The LTRO is a tool under which the RBI provides 1-3 year money to banks at the prevailing repo rate, accepting government securities with matching or higher tenure as the collateral.
• Funds through LTRO are provided at the repo rate.
• But usually, loans with higher maturity period (here like 1 year and 3 years) will have a higher interest rate compared to short term (repo) loans.
• According to the RBI, the LTRO scheme will be in addition to the existing Liquidity Adjustment Facility (LAF) and the Marginal Standing Facility (MSF) operations.
• The LAF and MSF are the two sets of liquidity operations by the RBI with the LAF having a number of tools like repo, reverse repo, term repo etc.

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• Finance Minister has said that India could not support a general allocation of new Special Drawing Rights (SDR) by the IMF because it might not be effective in easing coronavirus-driven financial pressures.
• FM Nirmala Sitharaman has stated that such a global liquidity boost by the IMF could produce potentially costly side-effects if countries used the funds for “extraneous” purposes.

Details of SDR mechanism:

What is SDR?

• The SDR is an interest-bearing international reserve asset created by the IMF in 1969 to supplement other reserve assets of member countries.
• To participate in this system, a country was required to have official reserves.
• This consisted of a central bank or government reserves of gold and globally accepted foreign currencies that could be used to buy the local currency.
• It is based on a basket of international currencies comprising the U.S. dollar, Japanese yen, euro, pound sterling and Chinese Renminbi.
• It is not a currency, nor a claim on the IMF, but is potentially a claim on freely usable currencies of IMF members.
• The value of the SDR is not directly determined by supply and demand in the market but is set daily by the IMF on the basis of market exchange rates between the currencies included in the SDR basket.

Who can hold SDRs?

• SDRs can be held and used by member countries, the IMF, and certain designated official entities called “prescribed holders”.
• It cannot be held, for example, by private entities or individuals.
• Its status as a reserve asset derives from the commitments of members to hold, accept, and honour obligations denominated in SDR.
• The SDR also serves as the unit of account of the IMF and some other international organizations.

General allocation of SDRs

• An SDR allocation is a low-cost way of adding to members’ international reserves, allowing members to reduce their reliance on more expensive domestic or external debt for building reserves.
• The IMF has the authority under its Articles of Agreement to create unconditional liquidity through “general allocations” of SDRs to participants in its SDR Department (currently, all members of the IMF) in proportion to their quotas in the IMF.

The SDR Interest Rate

• The interest rate on SDRs, or the SDRi, provides the basis for calculating the interest rate that is charged to member countries when they borrow from the IMF and paid to members for their remunerated creditor positions in the IMF.
• It is also the interest paid to member countries on their own SDR holdings and charged on their SDR allocation.
• The SDRi is determined weekly based on a weighted average of representative interest rates on short-term government debt instruments in the money markets of the SDR basket currencies, with a floor of five basis points.

How many SDRs have been allocated so far?

The general SDR allocation of August 28, 2009 is by far the biggest allocation to date:

• SDR 9.3 billion was allocated in yearly installments in 1970–72.
• SDR 12.1 billion was allocated in yearly installments in 1979–81.
• SDR 161.2 billion was allocated on August 28, 2009.

What happens to the SDRs once they are allocated?

• The IMF’s SDR Department keeps records of members’ SDR allocations and holdings; the SDR Department is also the channel through which all transactions and operations involving SDRs are conducted.
• Once allocated, members can hold their SDRs as part of their international reserves or sell part or all of their SDR allocations.
• Members can exchange SDRs for freely usable currencies among themselves and with prescribed holders; such exchange can take place under a voluntary arrangement or under designation by the Fund.
• IMF members can also use SDRs in operations and transactions involving the IMF, such as the payment of interest on and repayment of loans, or payment for future quota increases.

Issues with new allocations

• New reserves are allocated according to members’ quotas — or shares in the IMF.
• A great deal of the benefit in 2009 went to advanced economies that didn’t need help in accessing markets or financing fiscal deficits.
• If the same system is being used now, only 40 per cent of the total would be given to the emerging economies. That is not good enough.

Other reasons

• The possible extraneous purposes FM could be referring to maybe misuse of resources for terror funding or some such purpose by neighbours.
• This may seem far-fetched to some, but is par for the course for the government.
• The other possibility is that India is merely trying to prove its loyalty to the Trump administration.
• India has already requested to access the US Fed’s currency swaps.

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