The Monetary Policy is designed by the Central Bank to strategize the key factors in the economy to help control inflation and manage liquidity in the system. It helps lay down a structure for the banking system in the country. It aims to keep inflation and currency fluctuations in check while keeping an objective of growth.
The Reserve Bank of India (RBI) is the regulator and supervisor of India’s financial ecosystem. RBI formulates, implements, and manages the Monetary Policy. The Monetary Policy Committee (MPC) led by the Governor of RBI, usually meets every 2 months. The MPC uses a few monetary tools to formulate the current monetary policy. Understanding these tools in detail will give an insight into the operations of the RBI and how the monetary policy impacts the money supply in the system.
1. LAF – Liquidity Adjustment Facility
As the name suggests this tool is used to inject or absorb liquidity from the banking system. In 1998, Narasimham Committee on Banking recommended LAF. In April 1999, an interim LAF was introduced keeping ceiling and floor money market rates. Eventually, in June 2000, LAF was introduced full-fledged.
LAF has 2 components- Repo Rate and Reverse Repo Rate
- Repo Rate: Repo Rate is the rate at which Banks lend money from the RBI, in exchange for government securities. The word Repo stands for Repurchase Agreement. The banks sell the government securities to the RBI and repurchase them back at a predetermined rate and tenure. This lending helps to meet the shortage of funds at the bank’s end and helps in injecting liquidity into the banking system. Temporary collateral lending aims to assist banks in addressing short-term cash shortages that may arise during periods of economic instability or as a result of external forces beyond their influence. The repo rate is also colloquially called the policy rate. These rates have an impact on inflation; hence one will always see a rise in repo rates during rising inflation times. A rate cut is expected, when inflation is in control.
- Reverse Repo Rate: It is the mirror image of a repo rate. Here, RBI sells government securities to banks, to be bought back for a predetermined rate and date. In other words, the banks lend money to the RBI. It is a way to absorb excessive liquidity in the system. Also, it encourages banks to park their temporary surplus with the RBI in exchange for an interest incentive.
RBI undertakes auctions for repo rate agreements or reverse repo rate agreements. They are usually in multiples of Rs. 5 crores. The auctions generally happen on the CBS(e-Kuber) platform. Banks place their bids and a cut-off rate is later determined by the RBI. Commercial banks that maintain active current accounts and SGL accounts with the RBI are eligible to access the Liquidity Adjustment Facility. Nevertheless, Regional Rural Banks are prohibited from accessing the LAF.
Repo rates have been 4% in the last 3 years until May 2022, when RBI started hiking the rates. They were last hiked in Jan 2023 to 6.5%. In Feb, April, and June 2023, PMC declared no change in the policy rate, neither hike nor rate cut.
Raising the Repo rates can lead to higher borrowing expenses for both businesses and individuals, subsequently dampening the demand for goods and services. As demand decreases, producers may lower prices to entice buyers, thereby aiding in the management of inflation.
Repo Rate and Inflation:
When the Repo rates rise, it amplifies the borrowing costs for businesses and individuals, potentially diminishing the demand for goods and services. Consequently, producers may opt to lower prices in order to entice buyers, thereby aiding in the regulation of inflation. Also, banking rates on deposits improve, encouraging more investments in the economy, leading to more liquidity, and lesser spending, leading to a decrease in demand, eventually bringing prices down and helping control inflation.
Time Lag Effect: RBI has been continuously increasing its policy rates since May 2022. We see a few weeks’ time lag till the inflation rates start showing inverse traction.
Even when RBI took a pause on rate hikes in April 2023, we saw a fall in inflation rates on account of the effect of previous rate hikes
In the past year, we have seen several Variable reverse repo rate (VRRR) auctions by the RBI. A reverse repo rate helps banks park their excessive funds temporarily with the RBI, it helps absorb surplus liquidity. In VRRR auctions, RBI states details in a press release informing banks of the date and time for the auction, along with the notified amount. Usually, 30 minutes are given for banks to place bids and then a cut-off rate is decided. The rate at or above the repo rate is the rep considered void.
Variable Reverse Repo Rate Auctions in the past quarter (April-June 2023):
|Notified Amount (Rs. in crores)
|Offers Received and Accepted (Rs. in crores)
|Cut-off Rate (%)
|Tenure of Reversal
Except, for the month of June 2023, there have been 2-3 VRRRs in every month in the previous financial year. In June 2023, there has been an expectation of over surplus in liquidity especially with notes of Rs. 2000 being deposited and a reduction in inflation but banks have given a muted response to the auctions (except 19 June). The banks may have been cautious on account of heavy outflow due to advance tax and GST payments.
2. MSF (Marginal Standing Facility) and SDF (Standing Deposit Facility)
- Marginal Standing Facility (MSF) was started in 2011. It gave scheduled commercial banks a provision to borrow from the RBI in an emergency situation when inter-bank liquidity was compromised. The process is similar to LAF, where the RBI will purchase G-Securities to sell it back at a fixed date and rate. The MSF lending rate is 100bps more than the repo rate under LAF. Banks are allowed to borrow funds upto 1% of their NDTL (net demand and time liabilities)
* From December 2020, RBI has extended the scope of LAP and MSF to include Rural Regional Banks. This is to help boost efficient liquidity management at the pan-India level.
- Standing Deposit Facility (SDF) is an option given by RBI to banks to park excess funds without collateral. It is like the reverse repo rate but without any collaterals. RBI announced SDF in April 2022, as an additional facility to help absorb surplus liquidity.
Both MSF and SDF will be available, throughout the year, all days of the week.
* LAF corridor is known as the difference between the repo rate(cap) and reverse repo rate(floor). When SDF was introduced, it replaced FRRR (fixed reversible repo rate) as the floor for the LAF corridor.
3. CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio)
- Cash Reserve Ratio (CRR). It is a monetary policy tool used by central banks to regulate the amount of funds that commercial banks must maintain as reserves with the central bank. The reserve requirement is usually expressed as a percentage of a bank’s total deposits or liabilities. CRR helps in controlling loans made by banks. When the central bank raises the Cash Reserve Ratio (CRR), banks are obligated to keep a greater portion of their deposits as reserves, leading to a decrease in the available funds for lending. Conversely, when the central bank lowers the CRR, banks have more capital available for lending, potentially fostering economic expansion.
*Since Feb 2023, banks were urging RBI to allow amounts parked in dormant accounts to be used as CRRs. Almost Rs. 50,000 crores are locked up in the same. There has been no update from the RBI on this front yet.
- Statutory Liquidity Ratio (SLR): It is a regulatory requirement set by RBI that mandates commercial banks to maintain a certain percentage of their net demand and time liabilities (NDTL) in the form of specified liquid assets, such as government securities, cash, or gold. The purpose of SLR is to ensure the liquidity and solvency of banks and to control the expansion of credit in the economy.
4. Open Market Operations (OMO):
Open Market Operations are the buying and selling of government securities (such as Treasury bills and bonds) by the central bank in the open market. The objective is to regulate the money supply in the economy and manage liquidity in the banking system. When the central bank aims to expand the money supply, it buys government securities from banks and other financial institutions. This injects money into the system, providing liquidity to banks and encouraging lending and economic activity. Conversely, when the central bank wants to reduce the money supply, it sells government securities, thereby absorbing excess funds from the system and reducing liquidity.
Rates as per the latest Monetary Policy Meeting (June 2023)
|Fixed Reverse Repo Rate
|Standing Deposit Facility
|Marginal Standing Facility
|Current Reserve Ratio
|Standard Liquidity Ratio
To summarize, the monetary instruments employed by the Reserve Bank of India, including the Cash Reserve Ratio (CRR), hold significant importance in governing the nation’s economy. Through CRR adjustments, the central bank can impact the lending capacity of commercial banks and effectively manage liquidity within the banking system. This control over liquidity enables the RBI to effectively manage inflation, foster economic growth, and ensure the maintenance of a stable and sustainable financial landscape for the country.