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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 basically used by RBI to keep inflation under control.

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This article covers the following:

  1. How does Repo Rate work?
  2. What are the components of a Repo transaction?
  3. How does Repo Rate affect the economy?
  4. What is meant by Reverse Repo rate?
  5. Current Repo Rate and its impact

 

1. How does Repo Rate work?

When you borrow money from the bank, you need to pay interest on the principal charged by the bank. You may call this as the cost of credit. In the same manner, banks may have to borrow money from the RBI at times whenever there’s a shortfall. And when they borrow money from the RBI, they have to pay interest to them. The RBI lends money to the commercial banks at repo rate.

Technically, a repo is also known as “Repurchasing Option”. It is a contract in which banks provide eligible securities such as Treasury Bills to the RBI while availing overnight loans with a commitment to buy them back at a predetermined price. The interest rate charged on repo transactions is called repo rate.

 

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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 (securities recognized by the RBI and at the same time which are above the Statutory Liquidity Ratio limit).

b. RBI gives 1 day or overnight loan to the bank.

c. RBI charges an interest rate called repo rate from the bank.

d. Banks repay the loan after one day and repurchase the security it has given as collateral.

 

Repo Rate

 

3. How does Repo Rate affect the economy?

Repo rate is one of the components of the monetary policy of the RBI which is used to regulate the money supply, level of inflation and liquidity in the country. Additionally, the levels of repo rate have a direct relationship with the cost of borrowing for banks. The higher the repo rate, higher is the cost of borrowing for banks and vice-versa.

During high levels of inflation, attempts are made to reduce the money supply in the economy. For this, RBI increases the repo rate, makes it costly for businesses and industry to borrow money. This, in turn, slows down investment and reduces the supply of money in the economy. As a result, the growth of the economy is negatively impacted. However, this also helps bring down inflation.

On the other hand, when the RBI needs to pump funds into the system, it lowers repo rate which makes it cheaper for the businesses and industry 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 which the RBI offers to banks when they deposit their surplus cash with the 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 and earn interest on the deposited 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 rate which encourages the banks to park more funds with the RBI to earn higher returns on idle cash. In this way, excess money is drained out of the banking system. Banks are left with lesser cash to extend loans which curbs the purchasing power of individuals.

Repo RateReverse Repo Rate
It is the rate at which RBI lends money to banksIt is the rate at which RBI borrows money from banks
It is higher than reverse repo rateIt is lower than repo rate
It is used to control inflationIt is used to control money supply
It involves sale of securities which would be repurchased in future.It involves transfer of money from one account to another.

 

5. Current Repo Rate and its impact

RBI keeps changing the repo rate and reverse repo rate according to changing macroeconomic factors. Whenever RBI modifies the rates, it impacts every sector of the economy; although in different ways. Some segments gain as a result of the rate hike while others may suffer losses. Looking at the built up of inflationary pressures, RBI recently hiked the repo rate by 25 basis points to 6.50% and the reverse repo rate to 6.25%.

In some instances, big loans like home loans might be impacted due to a change in the reverse repo rates. If the RBI cuts the repo rate, it need not necessarily mean that the home loan EMIs would get lesser or the interest rates would get reduced as well. The lending bank also needs to reduce its ‘Base Lending’ rate for the EMIs to decrease. Home loan rates or fixed rate consumer loans aren’t impacted by RBI’s rate cut. The rate of interest is fixed with respect to fixed loans.

 

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