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Cutting Rates to [Effectively] Zero


Tamal Bandyopadhyay writes about how RBI can cut rates to zero.

Can RBI do this? Can it be even more bold and bring down the policy rate to zero? Yes, it can, through the back door.

Let’s listen to an imaginary conversation between a banker and a borrower to understand the predicament of different entities in the Indian financial system and how RBI can actually cut its policy rate to zero.

Borrower: Does this mean there won’t be any more rate cut?

Banker: I am not saying so. RBI can cut its repo rate and bridge the gap between repo and reverse repo rates, which is one and a half percentage points now.

Borrower: Will that help?

Banker: Hardly. Theoretically, the rate in the overnight call money market— from where banks borrow to tide over temporary asset-liability mismatches— should move in the corridor between repo and reverse repo rates. If the corridor shrinks, the volatility in the overnight call money rates will diminish. But with plenty of liquidity in the system, call money is moving at the lower end of the corridor and there is no volatility.

Borrower: Experts have been suggesting that RBI should bring down its policy rates further to bolster the slowing economy. What should the central bank do now?

Banker: It can bring down the policy rate to zero.

Borrower: Just now you said the policy rate cannot go down below 3.5%. [Savings account rate]

Banker: RBI can reduce it to zero through the back door.

Borrower: How?

Banker: It should stop sucking money out through its reverse repo window.

The article makes you think. Some salient points:

  • Banks can’t cut lending rates without cutting deposit rates.
  • Deposit rates can’t go under 8% because small savings schemes – NSC, Post Office etc. – offer 8%. [SS rates can’t be cut because of political reasons. Or, wait for new government]
  • PLR of banks can’t be cut because they must offer certain loans linked to PLR and below it. They would rather keep PLR there, and give greater discounts to PLR for new customers. [This is so disgusting. The concept of a PLR was to allow people to get lower rates if rates went down. Bankers are pricks.]
  • Reverse Repo – the rate at which banks can park funds with the RBI – can’t go below 3.5% as that is the savings bank rate. [Political reasons why that can’t be cut]
  • If Repo is brought to 3.5% the gap between repo and rev. repo is cut, so some leeway is there.
  • RBI can stop taking reverse repo. If it refuses to accept more than 1% of deposits another 25K crores will be undeployed by banks – who conveniently place the money with the RBI. So they’ll be forced to lend. [Or buy bonds, I guess]

Stuff in the brackets are my comments.


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