Will RBI go for a hike in reverse repo rate?

Market participants have said that the huge borrowing programme announced by the government in the Union Budget may prompt the central bank to hike the reverse repo rate. The government announced a gross borrowing of Rs 14.1 trillion for the next financial year. 

Let us understand why the RBI may go for a hike in the reverse repo rate and not the repo rate. 

The RBI adopted an ultra-loose monetary policy after the pandemic broke out. In order to inject liquidity into the system to spur growth it slashed the repo rate to record low of 4%. The rate has been held at that level since May 2020.

Repo rate is the rate the RBI charges when it lends money to banks for the short term. A cut in the repo rate results in commercial banks lowering interest rates, in turn encouraging businesses to borrow at low rates.

At the same time, what depositors receive on their savings and fixed deposits would also fall. This is meant to motivate the public to increase consumption. 

Meanwhile, the reverse repo rate is the rate that the RBI pays banks when they park their excess liquidity with it. The rate has remained unchanged at 3.35% since May 2020 after a sharp reduction of 155 basis points that year.

The lower reverse repo rate acts as a disincentive for banks to keep their surplus money with RBI, pushing them to give out loans. 

During normal times, the gap between the two key rates, which is also known as the policy corridor, is 25 basis points. This gap was widened by the central bank to 65 basis points after the onset of the Covid-19 pandemic. 

The RBI is widely expected to start policy rate normalisation and bring down the gap back to 25 basis points. It is looking to absorb the excess liquidity in the market as concerns over the Omicron variant wane. India’s daily Covid cases have fallen from a high of 3.48 lakh on January 21 to 1.49 lakh on Friday. 

The move will also rein in inflationary pressures in the economy. Retail inflation, which is the yardstick for the RBI policy making, hit a five-month high of 5.59% in December. The central bank has a target of 4% inflation, with a variation of 2% on both sides. 

Global cues will also influence RBI’s decisions. The Bank of England on Thursday raised interest rates by 0.25 percentage point to 0.5% to contain spiralling inflation while the US Federal Reserve signalled a first rate hike in March. 

Most analysts expect the RBI to hike reverse repo rate by as much as 40 bps on Wednesday before starting to raise the repo rate from April.

RBI’s normalisation drive will, however, lead to higher interest rates in the economy. Banks will pass on any hike in repo rate by increasing interest rates on loans. 

On the back of RBI’s accommodative monetary policy, home loan rates had fallen to multi-year lows in the past two years with some leading lender offering home loans starting at 6.75.

As most home loan rates are linked to the repo rate, they will see an uptick as the RBI benchmark rate is hiked. 

Following the Union Budget, the yield on the 10-year government bond jumped to 6.92%. This means the government is borrowing at a higher cost compared to some buyers. And this situation is not expected to last long. 

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