Understanding repo, reverse repo and CRR

How many times have we heard that a small retail investor at the beginning of a bull market has become mega rich by the end of it?

Most of the times we remain from where we started. The rich get richer and the poor get poorer. Obviously the question that arises is what does it take to graduate from middle class to rich class? There are no simple answers here, but one of the first things that come to the mind is the language of money.

Till the time we don't understand money's language, we just cannot master the art of making and preserving money.

As mentioned in the previous article (http://getahead.rediff.com/slide-show/2009/may/15/slide-show-1-understanding-the-language-of-money.htm), we will focus on understanding market terminology, so that we will be able to analyse the developments ourselves and thereby reduce dependence on external assistance or advice.

Here are some basic terminologies used in debt markets.

Debt market is a place where debt paper, like say government bonds, is traded. It is no physical place; it is a platform, where buyers and sellers trade debt paper, something roughly similar to a stock market.

Debt paper is a paper, which is issued by a borrower when s/he takes a loan (debt). If a borrower takes a loan of Rs 100 for a period of 10 years @ 10 per cent, then the paper which he issues to the lender is the debt paper. The debt paper issued will have a face value of Rs 100 (as that is the loan given), maturity of 10 years (as that is the term of the loan) and Coupon (interest rate) of 10 per cent.

Coupon is the interest the borrower promises to pay to the lender. This never changes. In our example, the lender will continue to get Rs 10 as interest every year for the next 10 years.

It is important to note that neither the face value nor the coupon of a bond changes. What changes are the market value and the yield (in simple terms interest earned on investment). In the previous article we had seen, if interest rates go down the market price of the bond goes up and consequently its yield comes down.

Disclaimer: This article is for information purposes only. Please do not take investment decision based on this article.

The author is a financial trainer for National Institute of Securities Market (Securities and Exchange Board of India's investor awareness arm), Bombay Stock Exchange and leading mutual funds. He runs a website www.moneybee.info and can be reached at ashutosh@moneybee.info.

In bond markets, interest rates are the most important factor, and the RBI controls interest rates.

RBI uses various rates like repo, reverse repo and CRR to give direction to interest rates in the country. Lets us understand each one of these in detail.

Repo comes from the words 'repurchase obligation'. In case of tight liquidity conditions (as you saw in 2008), when banks need funding for the short term, they approach the RBI and ask for a temporary loan. RBI gives them a loan only after taking some collateral. This collateral is Government Securities (G-Secs). (What are G-Secs? Next article will focus on that!)

So banks give G-Secs to RBI and take money to meet their temporary requirements. The interest rate which RBI charges to banks for such short-term loan is known as the repo rate. After the short-term period is over, banks have the obligation to repay the money back to RBI, along with the interest and 'buys back' its G-Secs, hence the word repurchase obligation.

It must be understood that when RBI does not want more money to go into the economy, it will raise this rate. When repo rate increases, the cost of money for banks also increases. Banks in turn increase the interest rates for their borrowers (that is, people like you and me). This prevents borrowers from taking loans from banks and thus RBI's objective of controlling money supply is achieved.

The only fallout of this is that while inflation gets controlled growth slows down as people don't borrow.

Reverse repo is that rate which RBI pays to banks.

When banks have surplus liquidity and there are not enough borrowings from banks by consumers (as is the condition now), banks park their surplus money with RBI and earn some minimum interest. The rate at which RBI pays interest is known as reverse repo rate.

It is only logical that repo rate will always be more than reverse repo rate.

When RBI wants the economy to grow, it will reduce reverse repo rate (as was seen recently in April). By doing so, it will give a signal to banks that instead of deploying surplus money with RBI for a low return they should deploy the same in projects in the economy, which will help to kickstart the economy.

In times of ample liquidity, repo rate is practically redundant. Hence you will observe RBI focusing more on cutting reverse repo rates in times of slowdown, as was seen in the recent past.

Cash reserve ratio (CRR) is that slice of a bank's deposits, which the bank has to compulsorily deposit with RBI.

A CRR of five per cent means that out of every Rs 100 which the bank gets as deposit, Rs 5 have to be deposited with RBI. Interestingly, RBI does not pay any interest on this money to banks. When RBI wants to reduce liquidity from the system, like in times of high inflation, it increases the CRR.

While repo rate acts as an indirect measure to control liquidity, CRR is a blunt weapon, which directly sucks liquidity from the system.

Consequently, when RBI is adopting an expansionary monetary policy, that is, when reviving growth and reducing inflation is not the main agenda, the CRR is reduced. Again, this has a direct and immediate impact on the liquidity.

In times such as these, when banks have plenty of funds but not much demand for money, they buy G-Secs more than the stipulated 24 per cent with the excess cash. As seen in the previous article, when interest rates go down, bond prices go up. So banks make a lot of money by their treasury operations in a falling interest rate scenario.

In this quarter (a three-month period after which most companies announce their results) keep an eye on bank results, and you will see the 'other income'; that is, treasury income contributing to banks' profits.

As interest rates reach their lows and consequently bond prices reach their highs, banks sell G-Secs (that is also the time when bonds are making headlines and sadly average retail investors are entering then, as was shown in the previous article!) and keep money ready for lending. This is because low interest rates attract consumers and corporates and banks start advancing loans to these entities.

This is not something new. Banks make money when rates are high as well as when rates are low. This has been happening for years. And if banks can do this so can we. But how many of us do this?

It is only the lack of knowledge of this language of money that the average investor never makes big money out of this 'officially available insider information'. Retail investors invest on some silly 'tips' or 'inside information' from their brokers but conveniently ignore such big tips the biggest insider in the economy -- RBI -- gives.

In the next article we will focus on the mathematics of debt markets. We have been saying that bond prices are inversely proportional to interest rate movement. In the article next week we will see why this happens.