In today’s Finshots, we offer a simplified explanation of what the Reserve Bank of India is doing with interest rates in the economy.

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The Story

Let me state it upfront. This is going to be an oversimplified explanation. And I am sure some of you will write back contesting the accuracy of some of these statements. However, there’s absolutely no way we can make this story accessible if we didn’t try to uncomplicate matters. And so we will soldier on anyway.

Alright then, on to the story.

Now, central banks are quite complicated entities. The kind of stuff they can do with money is honestly unimaginable. Take for instance our very own RBI. On Friday, they made the big announcement — no change in interest rates, they proclaimed. And then, surprise, surprise… they introduce a brand new idea called the Standing Deposit Facility that is expected to do some of the things a hike in interest rate would have achieved. In some sense, they eschewed the old principles, for something new. And that’s what we will be discussing today.

What is a Standing Deposit Facility?

But before we get there. Let’s see how interest rates work.

If you’ve been a reader of Finshots, you’ve probably seen some version of this explanation crop up in the past. But a little refresher course never hurt anyone. So here’s the basic idea.

Most central banks have two very important mandates. The first one is to keep prices in check — make sure inflation doesn’t eat into our savings. The second one is to support economic growth.

And in a bid to achieve these twin objectives they often rely on interest rates. When the RBI increases interest rates, it becomes more expensive for people and businesses to borrow money. When they reduce interest rates, people and businesses can borrow more easily. The more they borrow, the more they’re likely to spend. This spending spree can then help the economy come alive. At least in principle.

But if all this new demand for products and service pushes prices higher, then they’ll need to bump up interest rates. And when the RBI does push interest rates upwards, it should ideally temper prices if inflation is on the rise.

Simple!

However, the RBI can’t just fiddle with interest rates by whispering some magic words. No!

Instead, they have two levers to manipulate this item. The first lever is called the repo rate. It’s like this — When the RBI lends money to commercial banks, they fix a rate before they make the money available. That’s the repo rate and it stands at about 4% — the lowest it’s ever been in 20 years.

The second lever they have at their disposal is the reverse repo rate. It’s like the name indicates — When banks want to deposit money with the RBI, they can earn a fixed interest rate called the reverse repo rate which now stands at 3.35%.

And with these two levers, they can control all money supply.

Now here’s where things get interesting. After maintaining a low interest rate environment for quite some time, the RBI has reached a crossroads. The economy isn’t exactly booming and everybody knows it. But there’s an even bigger problem on the horizon — Inflation. If prices continue to rise, then the RBI will have to answer some very tough questions. So they need to mop up the extra money and hope that this will rein in prices.

And if you followed our explanation so far, you’d think that they would simply hike the repo rate — make it more expensive to borrow money.

It would have got the job done. But no, they didn’t do that. Instead, they introduced the Standing Deposit Facility — where banks can now park money with the RBI for a whopping interest rate of 3.75% instead. This, they hope will incentivize banks to park all the extra cash with the central bank. And if you think about it this way, you can see how this could mop up that extra money supply we talked about earlier.

In fact, they said so in a statement:

The extraordinary liquidity measures undertaken in the wake of the pandemic, combined with the liquidity injected through various other operations of the RBI have left a liquidity overhang of the order of ₹8.5 lakh crore in the system. The RBI will engage in a gradual and calibrated withdrawal of this liquidity over a multi-year time frame in a non-disruptive manner beginning this year.

In simple words they're saying — We introduced a lot of money into the economy to help people deal with the pandemic. But now there’s a lot of it floating around and we need to remove some of it carefully without disrupting matters.

But wait, that leaves us with one question. If we already have a thing called the reverse repo that allows banks to park money with the RBI, why is there a need for something else entirely? Which by the looks of it does the same exact thing.

Well, the answer is — It’s not the same exact thing.

See when banks park excess money with the RBI to earn that sweet “reverse repo”, the RBI is expected to post collateral. Collateral in the shape of government bonds. And banks can hold these government bonds to meet their own internal requirements. There are some mandates on that as well.

Anyway, with the Standing Deposit facility, the RBI doesn’t have to post collateral. It’s precisely why they’re offering a higher interest rate when compared to the reverse repo rate. And if you’re wondering why RBI doesn’t want to post collateral, well, it’s probably because they don't want to deal with as many government bonds. Think about it - Mopping up ₹8.5 lakh crores by hiking the reverse repo rate would involve lot of government bonds. And from the looks of it, the RBI doesn't seem like it wants to indulge in that kind of thing. So a Standing Deposit Facility offers a nice alternative and it can help them remove all that “overhang” (extra money) without the need for those pesky government bonds.

Until then….

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