MC EXPLAINER Why RBI wants to align call money rate to repo rate

Reserve Bank of India

The Reserve Bank of India (RBI) has sought the views of market participants on aligning overnight call money rate and the repo rate. The RBI has been working on this for the last few months.

The central bank has been trying to align the overnight call rate—which has been trading sharply lower amid huge surplus liquidity in the banking system—closer to the repo rate.

Here is an explainer to understand why the RBI wants to align both these rates.

Let us first understand, why the call money rate is trading below the repo rate

After the liquidity in the banking system turned positive and surged to a huge surplus, call money rates fell sharply. Additionally, the cut in repo rate by the central bank also led to easing of overnight rates.

On June 17, the call money rate was 21 basis points (bps) lower than the repo rate, compared to 10-15 bps in April when liquidity started turning positive. Prior to this, the call money rate was trading either at or over the repo rate as liquidity was in deficit.

What implications will it have if the gap between both rates is more?

Market participants said call money rates should be lower compared to the repo rate, but excessively lower rates can lead to inflation. This is because a surplus of cheaper funds leads to higher spending, which in turn leads to inflation.

Even though there are no concerns on the inflation front right now, the prevailing geopolitical tensions, along with cheaper funds, may have an impact on inflation, forcing the RBI to reassess the projection made earlier, experts added.

Is the call money rate significant for RBI?

Overnight call money rates are significant to the central bank because it impacts overall liquidity in the banking system and in turn could impact the economy as whole.

Will it have any impact on the exchange rate?

Money market experts are of the view that movement in the call money rates can have an impact on the exchange rates. Usually, overnight rates are considered the benchmark for rates on all other short-term debt instruments such as commercial papers, certificates of deposit and treasury bills, among others. This means that when the call money rate drops, the rates on other instruments follow.

Higher call money rates allow other instrument rates to rise, making investments attractive for foreign investors, leading to demand for currency. This leads to currency appreciation.

Similarly, low rates would make the currency less attractive to foreign investors, reducing demand for domestic currency and depreciating its value.

Who benefits from this?

The gap between the repo and overnight call money rates helps banks to avail of funds at cheaper funds from the market compared to RBI’s liquidity operation.

Also, it helps to cut down their borrowing costs and has a positive impact on profitability.