1. How does Repo Rate work?
When you borrow money from the bank, they charge an interest on the principal. Basically, it is cost of credit. Similarly, banks too can borrow money from RBI during cash crunch on which they must pay pay interest to the Central Bank. This interest rate is 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 buy them back 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-recognized securities that are above the Statutory Liquidity Ratio limit).
b. RBI gives 1 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 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 reduce the money supply 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 repo rate. Consequentially, 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 banking system. Banks are left with lesser cash 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 reverse repo rate||It is lower than repo rate
|It is used to control inflation||It 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; albeit 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, change in the reverse repo rates can impact big ticket loans like home loans. If the RBI cuts down this rate, it need not necessarily mean that the home loan EMIs would get lesser. Even the interest rates may not come down significantly. 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.