Rate Corridors

What are repo and reverse repo rates?

Repo rate is the rate of interest charged by the central bank when banks borrow money from it. It is the tool through which the RBI in-fuses funds into the system by lending to banks against pledging of securities.

The reverse repo is the rate the RBI offers to banks when they deposit funds with it. The RBI drains out liquidity from the financial system through reverse repo by releasing bonds to the banks. This is a daily operation by the central bank to manage liquidity Over a longer time, the RBI can also manage liquidity through open market operations.

What is an interest rate corridor?

Interest rate corridor refers to the window between the repo rate and the reverse repo rate wherein the reverse repo rate acts as a floor and the repo as the ceiling. Ideally, rates in the overnight interbank call money market, where lending and borrowing is unsecured, should move within this corridor. However, when banks are short of funds and the overnight call money rates are high and above the repo rate, banks approach the RBI to borrow under the repo window.

Therefore, the repo rate becomes an effective policy tool as it would help bring down the rates in the overnight market . The reverse hap-pens when money market rates fall below the reverse repo rate. Banks then park surplus funds with the RBI through a reverse repo trans-action. As a result, when there is excess liquidity in the system, the reverse repo is more effective. When liquidity is tight and banks need short-term funds from the RBI to manage mismatches, then the repo rate emerges as the effective policy rate. But if liquidity returns to the system the reverse repo would become the operative policy rate as the RBI would be draining out funds from the system.

Why is a narrow rate corridor desirable?

A narrow rate corridor means that short-term interest rates in the call money market will move within that band. This band was earlier 150 basis points, which has now been lowered to 125 basis points. Effectively, the narrower rate corridor will mean there will be less volatility in short term rates.

Do other central banks also have rate corridors?

Many developing countries have the rate corridors but central banks in developed and deeper financial markets have a single rate. In the US, for instance, the Fed Fund rate is the key interest rate. Short term funds are available at this rate to the eligible borrowers.