'Reversal repo rate' below 3.5% detrimental to economy: SBI Ecowrap

SBI report said that providing fiscal stimulus is the most effective solution in the current pandemic and it should be immediately provided in line with other countries

A 'reversal' repo rate below 3.5 per cent will be detrimental to lending in Indian economy in light of current capital constraint caused by coronavirus pandemic-led lockdown, SBI said in the latest Ecowrap report issued on Monday. The economists at State Bank of India believe that aggressive accommodative monetary policy rate, or lower rate, depresses rather than stimulates the economy as it negatively impacts bank's profits on new businesses by lowering its net interest margins.

"Our estimated results (log-liner model) based on 15 years data indicate that a reversal repo rate below 3.5 per cent will be detrimental for lending in an economy with tighter capital constraint," the SBI report said.

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, the report added.

What is Reversal Interest Rate? Reversal interest rate is that rate where risk-taking ability of the banking sector through tighter lending at lower rates is just adequate to cover the bank net worth. Any further rate cuts larger than reversal interest rate results in banks cutting back on their credit extensions and forced increase in their safe asset holdings through the feedback loop.

In a bid to mitigate the economic impact of coronavirus pandemic, countries across the globe are taking unprecedented measures, including aggressive accommodative monetary policy. Almost all major economies have cut their policy rates during COVD-19 (in the range of 15-275 basis points), with India reducing its repo rates by 115 bps to 4 per cent. 

Repo rate is the rate at which the central bank of a country lends money to commercial banks to maintain liquidity in the system. The Reserve Bank of India (RBI), in its second bi-monthly monetary meet of FY 2020-21 held on August 6, kept the key policy rates unchanged at 4 per cent with accommodative stance. The status quo was maintained after two consecutive rate cuts - in March and May 2020.

The report highlighted that even after years of qualitative easing, advanced economies have continued to undershoot even the minimum inflation target. 

Citing a 2018 NBER paper by Markus K Brunnermei-er and Yann Koby titled "The Reversal Interest Rate", the report said that if the central bank reduces the policy rate below such "reversal interest rate", it depresses the economy. Also, the reversal interest rate is not (necessarily) zero, it said.

The SBI report said that providing fiscal stimulus is the most effective solution in the current pandemic and it should be immediately provided in line with other countries. Countries are providing sizable fiscal support through immediate budgetary measures, as well as off-budget liquidity and the measures taken by the governments (in the US and Europe) to protect vulnerable firms and employees during the lockdown have largely met their goals, it said.

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