Invest in Mutual Funds &
Get More Returns

Start Investing

Repo rate refers to the rate at which commercial banks borrow money by selling their securities to the Central bank of our country i.e Reserve Bank of India (RBI) to maintain liquidity, in case of shortage of funds or due to some statutory measures. It is one of the main tools of RBI to keep inflation under control.

Click here to read about: CRR & SLR.

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’ or ‘Repurchase Agreement’. It is an agreement 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. Thus, the bank gets the cash and the central bank the security.

2. What are the Components of a Repo Transaction?

Below are the parameters on the basis of which the RBI agrees to execute the transaction with the banks:

Preventing Economy “squeezes” – The Central bank increases or decreases the Repo rate depending on the inflation. Thus, it aims at controlling the economy by keeping inflation in the limit.

Hedging & Leveraging – RBI aims to hedge and leverage by buying securities and bonds from the banks and provide cash to them in return for the collateral deposited.

Short-Term Borrowing – RBI lends money for a short period of time, maximum being an overnight post which the banks buy back their securities deposited at a predetermined price.

Collaterals & Securities – RBI accepts collateral in the form of gold, bonds etc.

Cash Reserve (or) Liquidity – Banks borrow money from RBI to maintain liquidity or cash reserve as a precautionary measure.

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 impact on the cost of borrowing for banks. Higher the repo rate, higher will be the cost of borrowing for banks and vice-versa.

a. Rise in inflation

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 by increasing the repo rate. This makes borrowing a costly affair for businesses and industries, which in turn slows down investment and money supply in the market. As a result, it negatively impacts the growth of the economy, which helps in controlling inflation.

b. Increasing Liquidity in the Market

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?

Reverse Repo Rate is a mechanism to absorb the liquidity in the market, thus restricting the borrowing power of investors.

Reverse Repo Rate is when the RBI borrows money from banks when there is excess liquidity in the market. The banks benefit out of it by receiving interest for their holdings with the central bank.

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 excess funds. Banks are left with lesser funds to extend loans and borrowings to consumers.

 

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 and deficiency of funds

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 5.15% from 5.75%. In the same line, the reverse repo rate was also reduced to 4.9% from 5.5%.

Changes in the repo rates can directly impact big-ticket loans such as home loans. The decrease in repo rates is to aim at bringing in growth and improving economic development in the country. Consumers will borrow more from banks thus stabilizing the inflation.

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.

Make Small Investments for Bigger Returns

Start SIP Now