Monetary Policy & Tools That RBI Uses

Industry leaders, investors, banks & NBFCs along with economists have all been waiting eagerly for the conclusion of MPC (Monetary Policy Committee) deliberations and if RBI will effect one more cut in the repo rate (its policy rate) or maintain status quo. The suspense is now over since the RBI has opted for a pause after the bimonthly MPC meeting in August 2025.
But how effective are these changes in the repo rate? What are the other instruments in the RBI’s arsenal and when & how are they used? These are some important issues that investors need to understand in some detail.

1. Repo Rate: It is the rate at which RBI lends to commercial banks. Through this the RBI communicates its policy intent. A cut in the rate conveys an expansionary, a hike contractionary and a pause, a status quo in the stance. The bond and the money markets, which, in India, are as yet mainly the domain of institutions, react to the changes immediately. A cut will generally increase the price of debt securities and vice versa for the hike. But given the institutional inertia and friction, banks and NBFCs transmit the rate changes with time lag and often only partially. However, through what is called the liquidity corridor, The RBI to some extent, implements the rate change directly. The Marginal Standing Facility (MSF) provides liquidity to the banks when required, which at present is available at 5.75% which is 0.25% higher than the prevailing repo rate. Similarly, when the banks have excess liquidity, they can deposit funds with RBI under Standing Deposit Facility (SDF) at 5.25%. So, the width of the liquidity corridor is 0.5% ensuring that call and money market rates, by and large stay within this corridor. By influencing the cost of funds, the change in repo rate seeks to control inflation or encourage investments when growth is sluggish. When too much money chases too few goods, a hike in the rate raises the cost of credit and makes deposit (savings) attractive. A rate change can also affect one’s investment portfolio. A repo rate cut means lower call money rates. Yields on short term debt instruments take their cues from call market rates. So, for instance, it is likely that 91 day Treasury Bill will earn less. Also, the yields on dated (long term) securities like the 10-year Govt Bonds or corporate bonds, will also fall though not proportionately, depending on their duration. Existing securities, however, will gain in value (called treasury gains) thereby raising the NAV (Net Asset Value) of debt mutual funds.
   For equities, the change in repo rate, essentially transmits itself by influencing the rate used to discount future cash flows of the company. Thus, a hike in rate cut will increase the cost of equity finance, while a rate cut will decrease the cost of such finance.
2. CRR: Cash Reserve Ratio (CRR) specifies how much of the bank’s deposits are required to be kept with the RBI as interest free reserve. RBI can infuse or drain out
   liquidity by reducing or increasing CRR and it can also be used as a buffer to some extent against liquidity mismatches between sources and uses of funds of the bank.
3. SLR: Statutory Liquidity Ratio (SLR) is the minimum percentage of bank deposits which has to be maintained in secure liquid assets like government securities. The securities are held by the banks themselves and hence SLR determines the quantum of money bank can lend and thereby influences the money supply in the economy. The policy governing SLR has come someway since the days when SLR was used as tool to provide, inter alia, a captive market to finance the deficit of the government and to some extent monetary seigniorage dictated SLR levels. RBI at present uses SLR more as a tool for controlling money multiplier and for protection of depositor’s funds and strengthening solvency of the banks.
4. OMO Auctions: RBI uses Open Market Operations (OMOs) to manage liquidity. When there is excess liquidity, it sells G-Secs thereby sucking out funds from the banking system. When it buys, the opposite will be the result. During sub-prime crisis and again the wake of Covid pandemic, many central banks resorted to, what came to be known as, “quantitative easing” which was nothing but a more aggressive form of OMO to flood sluggish economies with liquidity of a more durable kind, by buying bonds where such purchases sometimes even went beyond G-Secs. The result of such protracted quantitative easing was that the banking system was sloshing with liquidity bringing deposit rates to almost zero, thereby punishing savers and encouraging consumption/investment!
5. VRR Auctions: Variable Rate Repo (VRR) auctions are a tool to inject short term liquidity. When RBI perceives a liquidity crunch in the money market, it announces a VRR auction for an amount it considers adequate to address the liquidity gap. The auction could be for 14 days or even overnight, that is, one day. Through this window the banks borrow from RBI at rates higher than the repo rate.
   While both VRR and buying G-Secs in an OMO are meant to infuse liquidity, VRR auctions are used to address very short-term, often transient liquidity deficits. OMOs in general address longer-term deficits.
6. VRRR Auctions: Variable Rate Reverse Repo (VRRR) auctions are the obverse of VRR auctions. While VRR is used to provide liquidity, VRRR is used to absorb liquidity. Under VRRR auctions, banks can bid for an interest rate which the RBI would be paying them for parking excess funds with it. VRRR too is a short-term tool that impacts yields at the short end of the yield curve. Debt securities at the longer end and equities, largely remain immune from VRRR.
7. Provisioning: RBI does tweak the levels of provisions that banks are mandated to maintain, to discourage or mitigate risks involved in lending certain sectors, like unsecured personal loans.
   

Well, given the arsenal at the disposal of central banks, their job may appear pretty straight forward and it might be presumed that economies would respond to the use of these tools as expected. But economies have their own peculiarities and growth cycles. Further, as economies evolve and technologies emerge, monetary policy faces challenges galore. For instance, although the RBI has reduced the repo rate by 100 basis points since February this year and infused adequate liquidity, the response to these accommodative steps has been underwhelming with credit growing at less than 10 per cent. In fact, the daily average liquidity surplus, reported to be Rs 3 lac crores, reflects poor credit appetite, particularly on the investment front. It appears that in a milieu where demand is restrained by heightened uncertainty due to tariff shock, poor sentiment coupled with sluggish urban incomes, opening the spigots alone cannot spur credit growth and investment.

Besides the size of the informal economy and consequent predominance of cash in the currency in circulation can also dent the efficacy of monetary policy. Even within the formal economy the transmission of policy rate changes, may not be the same for large corporates who can access capital markets with better terms than say, MSMEs who have to largely depend on banks and NBFCs, who transmit the policy changes with time lag and not always entirely, given “institutional” friction. Globalization of country’s debt is again another challenge which the monetary policy has to contend with. And then of course, there is the challenge posed by ever changing technology. Blockchain technology, for instance, which has given rise to crypto currencies, such as Bitcoin is something that is increasingly transcending the environment regulated by Government monopolies like central banks and hence not amenable to the control and policy changes of monetary authorities. Some central banks, including RBI, have brought out CBDCs (Central Bank Digital Currency) to blunt the challenge posed by crypto currencies, but they have largely remained confined to the wholesale transactions of captive institutions. Now, Stablecoins, like the Tether (USDT) or Circle (USDC) which are pegged to a reference asset, like the US dollar, have the potential to draw investments from economies with weaker currencies to those with stronger ones notwithstanding CBDCs. So central banks along with Governments have to continuously innovate and invent new tools and regulations to stay relevant. Alas! In economics there is nothing like a permanent equilibrium state.