Saturday, January 28, 2006

Is this a conundrum ?

The RBI recently raised the repo rate (from 6.25% to 6.5%) and the reverse-repo rate (from 5.25% to 5.5 %). The reasons behind the move are better explained here. This is I think the third such hike in the last one year.

However, the hike in repo rates poses a difficult question in my mind - why is the bank rate (at 6 %) lower than the repo rate (6.5%) ? Does it mean that borrowing for a shorter term (via a repo transaction) from RBI will be more expensive than borrowing over a period that is greater than say 1 day (via the traditional bank rate) ?

Isn't the yield curve still positive in India ?

For those who do not understand what is a repo rate or reverse-repo rate -

Bank rate, sometimes also referred as rediscount rate, is the rate of interest which a central bank charges for loans and advances made available to commercial banks and other financial intermediaries. Changes in bank rate is widely used as a tool by the central banks to control the money supply. Current rate - 6%.

Repurchase agreements (Repos) are financial instruments used in the money markets. A more accurate and descriptive term is Sale and Repurchase Agreement, since what transpires is sale of securities now for cash by the bank to the RBI, with the promise made by the bank to the RBI of repurchasing those securities later (with the bank paying the requisite implicit interest to the RBI at the time of repurchase - the implicit interest rate is known as the repo rate). Current rate - 6.5%.

A Reverse Repo
is a transaction in which the bank lends money to the RBI (which is why the reverse repo rate is lower than the repo rate) against securities put up by the RBI. Current rate - 5.5%.


Tariq Chotani said...

My Friend,
Your Definition of Reverse Repo is right - theoretically. But a couple of Monetary Policy meetings ago, the RBI had changed the definition or rather swaped it with the international definition.

So now
Reverse Repo - Is a transaction where the Banks lend Securities (G-Secs) and get cash from the central bank.

And the repo is the reverse.

So with the Bank Rate @ 6% and the Reverse Repo (Earlier Repo) @ 5.5, The RBI still lends to the banks for short-term liquidity reasons at lower than the discont rate of 6%.

Ravi Purohit said...

Yes you are right. The nomenclatures were indeed changed. This is what the RBI says -

With effect from October 29, 2004 the nomenclature of Repo and Reverse Repo has been interchanged as per international usages. Till October 28, 2004, Repo indicated absorption of liquidity whereas Reverse Repo meant injection of liquidity by the Reserve Bank.

Which means - now Reverse Repo would mean absorption of liquidity (RBI borrowing cash from the banks and issuing securities @ 5.5%) and Repo would mean injection of liquidity (RBI lending cash @ 6.5% against the collateral SLR securities).

So, the question still remains - RBI lends @ 6% for a period greater than 3 days but, charges 6.5% for a shorter term (3 days under the Repo transaction), is this a conundrum ? Or am i missing anything ?