A ‘reversal’ repo rate below 3.5% will harm the economy, says SBI’s Ecowrap report

A “reversal” repo rate below 3.5 per cent will be detrimental for lending in the Indian economy with the current capital constraint, warned State Bank of India’s economic research department in its research report “Ecowrap”.

“We believe any further rate cuts will have the unintended impact on the economy. Instead, we strongly recommend for India an activist fiscal policy,” the report said.

“Reversal interest rate” is the rate at which accommodative monetary policy reverses its effect and becomes contractionary for output, the department said, referring to a 2018 National Bureau of Economic Research paper, in the report.

If the central bank reduces the policy rate below such “reversal interest rate”, the monetary policy rate depresses rather than stimulates the economy. Importantly, such reversal interest rate is not (necessarily) zero, the report added.

Repo rate is the interest rate banks pay the Reserve Bank of India for drawing liquidity from it to overcome short-term mismatches. Currently, this rate is at 4 per cent.

Interestingly, the estimated 3.5 per cent “reversal” repo rate also translates into the 1-year deposit not being lower by more than 25 basis points from the current levels, said Soumya Kanti Ghosh, Group Chief Economic Adviser, SBI.

SBI currently offers 4.90 per cent interest on a one-year to less than two-year retail domestic term deposit (below ₹2 crore).

“Interestingly, we find clear evidence of reversal repo rate creeping up over time, and in that sense banks will always prefer to hold assets of longer duration.

“For example, if bank assets are of shorter duration, then a longer interest rate cut might lead to larger NII (net interest income) profit losses than fixed income capital gains. An exceedingly long period of low rates may end up lower lending from today onwards, amid feedback effects on the banks' valuations,” Ghosh said.

Reversal interest rate and banks

When it comes to banks, in principle, the reversal interest rate is defined as that rate where risk-taking ability of the banking sector through higher lending by lower rates is just adequate to cover the bank net worth.

In this regard, the report emphasised that any further rate cuts larger than reversal interest rate results in banks cutting back on their credit extension and forced increase in their safe asset holdings through the feedback loop.

Fiscal expansion a must

The report observed that there is a plethora of research to show that fiscal multipliers are always larger when monetary policy is at the lower bound as investors anticipate a prolonged period of low interest rates thus accommodating the fiscal response without any negative impact on macro variables.

It emphasised: “We only expect the government to make a credible commitment to regain fiscal space once the economy recovers from crisis. But for now, fiscal expansion is a must.”