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Repo rate refers to the rate at which commercial banks borrow money from the Reserve Bank of India (RBI) in case of shortage of funds. It is one of the main tools of RBI to keep inflation under control.

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This article covers the following:

1. How Does Repo Rate Work?

When you borrow money from the bank, the transaction attracts interest on the principal amount. This is referred to as the cost of credit. Similarly, banks also borrow money from RBI during a cash crunch on which they are required to pay interest to the Central Bank. This interest rate is called the repo rate.

Technically, repo stands for ‘Repurchasing Option’. It is a contract in which banks provide eligible securities such as Treasury Bills to the RBI while availing overnight loans. An agreement to repurchase them at a predetermined price will also be in place. So, this interest rate is levied on these kinds of repo transactions as well.

2. What are the Components of a Repo Transaction?

The components of a repo transaction between the RBI and the bank are as follows:

a. Banks provide eligible securities (RBI-recognised securities that are above the Statutory Liquidity Ratio limit).

b. RBI gives one day or overnight loan to the bank.

c. RBI charges an interest (repo rate) from the bank.

d. Banks repay the loan after one day and repurchase the security they gave as collateral.

3. How Does Repo Rate Affect the Economy?

Repo rate is a powerful arm of the Indian monetary policy that can regulate the country’s money supply, inflation levels, and liquidity. Additionally, the levels of repo have a direct relationship with the cost of borrowing for banks. Higher the repo rate, higher will be the cost of borrowing for banks and vice-versa.

a. When inflation rises

During high levels of inflation, RBI makes strong attempts to bring down the flow of money in the economy. One way to do this is to increase the repo rate. This makes borrowing a costly affair for businesses and industries, which in turn slows down investment and money supply in the economy. As a result, it negatively impacts the growth of the economy. This also helps bring down inflation.

b. When RBI wants to flow cash into the system

On the other hand, when the RBI needs to pump funds into the system, it lowers the repo rate. Consequently, businesses and industries find it cheaper to borrow money for different investment purposes. It also increases the overall supply of money in the economy. This ultimately boosts the growth rate of the economy.

4. What is Meant by Reverse Repo Rate?

A Reverse Repo Rate is a rate that RBI offers to banks when they deposit their surplus cash with RBI for shorter periods. In other words, it is the rate at which the RBI borrows from the commercial banks. When banks have excess funds but don’t have any other lending or investment options, they deposit/lend the surplus funds with the RBI. This way, banks can raise additional interest from their funds.

The reverse repo rate has an inverse relationship with the money supply in the economy. During high levels of inflation in the economy, the RBI increases the reverse repo. It encourages the banks to park more funds with the RBI to earn higher returns on idle cash. As a result, every excess rupee is put to use in the banking system. Banks are left with lesser funds to extend loans, curbing the purchasing power of individuals.

Repo Rate

Reverse Repo Rate

It is the rate at which RBI lends money to banks

It is the rate at which RBI borrows money from banks

It is higher than the reverse repo rate

It is lower than the repo rate

It is used to control inflation

It is used to manage cash-flow

It involves the sale of securities which would be repurchased in future.

It involves the transfer of money from one account to another.

5. Current Repo Rate and its Impact

RBI keeps changing the repo rate and the reverse repo rate according to changing macroeconomic factors. Whenever RBI modifies the rates, it impacts all sectors of the economy; albeit in different ways. Some segments gain as a result of the rate hike while others may suffer losses. RBI recently cut down the repo rate by 25 basis points to 5.75% from 6%. In the same line, the reverse repo rate was also reduced by 25 basis points to 5.5% from 5.75%.

Changes in the repo rates can directly impact big-ticket loans such as home loans. An increase/decrease in the repo rates can result in banks and financial institutions revising their MCLR proportionately. The Marginal Cost of Funds Based Lending Rate or the MCLR is the benchmark rate below which a bank/financial institution cannot lend.

A decline in the repo rate can lead to the banks bringing down their lending rate. This can prove to be beneficial for retail loan borrowers. However, to bring down the loan EMIs, the lender has to reduce its base lending rate. As per the RBI guidelines, banks/financial institutions are required to transfer the benefit of interest rate cuts to consumers as soon as possible.

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