Explanation:

In a recent report, State Bank of India, which is the largest public sector bank in the country, has stated: “…we believe the stage is set for a reverse repo normalisation.” 

• Repo rate is the interst rate at which RBI lends to banks

• The reverse repo is the interest rate that the RBI pays to the commercial banks when they park their excess “liquidity” (money) with the RBI. The reverse repo, thus, is the exact opposite of the repo rate. Under normal circumstances, that is when the economy is growing at a healthy pace, the repo rate becomes the benchmark interest rate in the economy. That’s because it is the lowest rate of interest at which funds can be borrowed. As such, the repo rate forms the floor interest rate for all other interest rates in the economy — be it the rate you pay for a car loan or a home loan or the interest you earn on your fixed deposit etc.

• When there is a situation where the RBI pumps more and more liquidity into the market but there are no takers of fresh loans — either because the banks are unwilling to lend or because there is no genuine demand for new loans in the economy. In such a scenario, the action shifts from repo rate to reverse repo rate because banks are no longer interested in borrowing money from the RBI. Rather they are more interested in parking their excess liquidity with the RBI. And that is how the reverse repo becomes the actual benchmark interest rate in the economy.

What does reverse repo normalisation mean?

Simply put, it means the reverse repo rates will go up. Over the past few months, in the face of rising inflation, several central banks across the world have either increased interest rates or signaled that they would do so soon.

In India, too, it is expected that the RBI will raise the repo rate. But before that, it is expected that the RBI will raise the reverse repo rate and reduce the gap between the two rates. In the immediate aftermath of Covid, RBI had increased this gap (See CHART).

SBI first expects the reverse repo to go up from 3.35% to 3.75% while the repo rate continues to be 4%. Doing this will incentivise commercial banks to park excess funds with RBI, thus sucking some liquidity out of the system. The next step would be raising the repo rate.

This process of normalisation, which is aimed at curbing inflation, will not only reduce excess liquidity but also result in higher interest rates across the board in the Indian economy — thus reducing the demand for money among consumers (since it would make more sense to just keep the money in the bank) and making it costlier for businesses to borrow fresh loans.

Hence both statements are correct.