Is the latest RBI policy suggesting that interest rates will start going up? I think yes! 

The pandemic-induced crisis prompted the government to undertake measures such as infusing liquidity into the system to maintain the stability of the financial system and prevent the weakening of the economy. How does it work and will the interest rates increase soon?

(Q) What’s the background?

In situations like COVID & others where there can be a challenge to businesses, job losses, etc., the government through the central bank tries to maintain high liquidity in the system.

(Q) What does high liquidity mean?

Keep interest rates low to encourage businesses & individuals to borrow & invest so that job losses can be reduced & demand for goods can be maintained. For example, if the rates are low, Real Estate developers can borrow cheap & build more (reduce job losses), while buyers can borrow cheap & buy more houses (demand is maintained).

(Q) How are the rates kept low?

Rates are kept low by managing,

– Repo & Reverse Repo Rates

– Buying Bonds from the market (also known as GSAP)

– Operation twist

Let me explain,

(Q) What are Repo and Reverse Repo rates?

Repo rate is the rate at which commercial banks borrow money from RBI for overnight. So, when banks borrow from RBI for 1 night, banks pay a 4% per annum equivalent rate for one day called Repo Rate.

Reverse repo is a rate at which commercial banks lend to RBI for overnight. So, when banks lend to RBI for 1 night, banks receive a 3.35% per annum equivalent rate for one night of lending from RBI called the reverse repo rate.

While this is not completely practical, imagine this, if RBI decreases Repo rate, banks get money cheaper & hence can lend cheaper. So, if the original rate was 5% of repo, the lending by banks to others happened at 5% + something & now that RBI has decreased the rates, lending happens at 4% + something. So, reducing repo reduces the lending rate theoretically & hence invites businesses & individuals to borrow more & invest.

Similarly, when RBI reduces the reverse repo rate from let’s say 4% to 3.35%, it disincentives banks to lend to RBI because banks were earlier getting 4% to lend to RBI & now will get only 3.35% whereby instead of lending to RBI, they ‘might’ use that to increase lending to businesses & individuals.

So, if RBI wants to increase liquidity and/or incentivize banks to lend, RBI will reduce repo & reverse repo rates.

(Q) What is GASP?

To increase liquidity, RBI also does Bond buying / GSAP or Quantitative Easing like popularly called in the western world. GSAP is a government security acquisition program. Indian government like most other governments runs a fiscal deficit. Income is less than the expense. So, if income is 100 & expense is 105, the 5 rupees is borrowed & a bond is issued vs that promising a fixed return for a fixed time like in an FD.

When RBI wants to increase liquidity in the market, RBI buys back the bonds issued earlier for fiscal deficit before its maturity. So, when RBI buys back the bonds, it has to pay the banks & that’s how liquidity is infused in the banking system. Banks have more cash/liquidity now & it’s an assumption that banks will increase lending now.

(Q) What happens when so much liquidity is infused into the system?

Rates across time frames fall as there is more supply of money in the system. From borrowing overnight to borrowing for 10 years, all fall. This can be discomforting for RBI after a point in time.

(Q) Why would RBI have a problem?

Assume reverse repo (the rate at which RBI borrows from the banks) to be at 3.35% & imagine other market rates to be so low that Reliance can borrow for 3 months at a rate lower than RBI @ 2.75%, weird right?

(Q) You might ask how is it possible?

Imagine banks flooded with liquidity & RBI not willing to take money from the banks under reverse repo (as RBI wants to keep liquidity in the system & not absorb it), what will banks do keeping it with themselves? They start lending to large entities at a lower cost.

(Q) What does RBI do now? It does not want to increase rates & also manage the above situation.

The answer is an Operations twist.

(Q) What’s Operation Twist?

RBI wants to increase rates at the short end (less than 1 year lending) but does not want to increase at the higher end (10 years). So, they sell more bonds (issue new bonds) at the short end & keep buying bonds (GSAP) at the longer end.

(Q) How does this help?

Bond price & yields are inversely related. When the bond price goes up, the yield falls & when the bond price falls, yields go up. More on this if you don’t know the concept –

When RBI buys bonds (GSAP) in huge volumes at the longer end, there is demand for bonds & hence price goes up & the yield falls. When RBI sells bonds (issues new bonds) at the lower end, there is a supply of bonds, bonds fall in value & the yields go up.

By this, shorter end rates/yields increases & long end is managed (does not increase much), this is operations twist

(Q) What’s happening now?

– RBI has stopped operations twist

– RBI in the bi-monthly policy also said they will stop the GSAP

– It also proposed to conduct 14 days long term variable reverse repo

(Q) So what?

-If RBI stops GSAP/Operations twist, demand for bonds at the longer end will reduce, and hence rate/yield will go up. It’s up by 0.20% already

-If RBI starts accepting liquidity under reverse repo (that it limited so that the banks could lend more, remember the Reliance example?) that too variable, banks will lend more to RBI.

(Q) Variable reverse repo?

Unlike overnight reverse repo at 3.35%, RBI announced that it will take money from banks for 7 & 14 days and the rate will be decided by an auction (variable rate). Just for your info, in an auction, instead of 3.35%, the money was lent by banks to RBI at close to 4%. Do you see rates going up here?

These are the indications that RBI is now comfortable with rates going up and liquidity falling from the system, in my opinion. This will further get confirmed when the spread between Repo & Reverse Repo which currently is at 0.65% (4% – 3.35%) will come down to 0.50% (4% – 3.5%) when the reverse repo rate will be increased from 3.35% to 3.5% in the worst case or even higher.