RBI Policy Demystified

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Decisions by the central bank of our country effects us directly as investors as well as borrowers of money. It is important to know what RBI action on various fronts does to your financial situation.

To aid its primary goals of controlling inflation, the RBI uses several measures. Let's understand what each of these measures are and how they impact you.

REPO and Reverse REPO - Banks are in the business of borrowing and lending and often need very short term funds to meet their liquidity requirements. Let's take an example of a bank that needs to borrow money for day. Our bank may be holding on to securities that don't mature in a day. Instead of selling securities in the market it can instead sell the same to the RBI, get funds to meet its short term requirement and then buy the same securities back from the RBI. This is called the REPO - short for repurchase agreement and the bank pays to RBI a rate of interest for the funds used. The REPO rate is thus the very short term rate at which banks borrow from RBI. Reverse REPO is when a bank has excess liquidity and buys securities from the RBI with an agreement to sell them back to the RBI. REPO is part of the overnight money market and an important tool for RBI and bankers in managing short term liquidity requirements. Increase in the REPO rate impact the cost of borrowing for banks, which is in turn passed on to borrowers.

SLR stands for statutory liquidity ratio and CRR stands for Cash Reserve Ratio. Banks are required to maintain a certain percentage of their assets in RBI approved securities which form part of SLR and very liquid assets which form part of CRR. They can use the rest of their funds to either lend or further invest in securities of their choice. So if RBI wants banks to lend lesser money; it simply increases the SLR and CRR. This way banks will have to keep more money in approved securities and would hence have lesser money to lend. Lesser money to lend leads to a general increase in interest rates. The reverse happens when both these ratios are reduced.

While REPO and Reverse REPO rates are announced by the RBI, it may also conduct auctions of existing government securities in what is called an open market operation or OMO for short. These are called OMO as banks and other participants in the bond market are invited to tender bids for securities that are bought or sold auction style. OMOs are generally a tool in stabilizing and reducing volatility in bond markets as well as controlling money supply in the short term.

The bank rate is the rate at which RBI lends to banks and any change in this rate is mostly considered a direct signal to increase or reduce rates.

Most of these measures may not necessarily means that bank deposit rates or loan rates will increase or decrease immediately. Banks may evaluate the overall impact and take a call on these with a lag effect. But overall an increase or decrease in these rates indicate RBI intention to tighten or loosen money supply and thus also the movement of interest rates.

Since listed debt securities will immediately price these in, for investors in long term bonds/ debt mutual funds the impact will be noticed immediately.

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