Understanding Repo Rate and Reverse Repo Rate

The repo rate is the rate at which commercial banks borrow money by selling their securities to our country's central bank, the Reserve Bank of India (RBI), in order to maintain liquidity in the event of a fund shortage or due to statutory measures.

It is one of the RBI's primary tools for keeping inflation under control.

How Does the Repo Rate Work?

When you borrow money from a bank, you will be charged interest on the principal amount. This is known as the cost of credit.

Similarly, during a cash crunch, banks borrow money from the RBI and are required to pay interest to the Central Bank. The repo rate is the name given to this interest rate.

Repo Rate Full Form: Repo is an abbreviation for ‘Repurchasing Option' or ‘Repurchase Agreement.' It is an agreement in which banks provide the RBI with eligible securities such as Treasury Bills in exchange for overnight loans.

There will also be an agreement in place to repurchase them at a predetermined price. As a result, the bank receives the cash and the central bank receives the security.

What Constituents a Repo Transaction?

The following are the parameters under which the RBI has agreed to carry out the transaction with the banks:

  • Preventing “squeezes” in the economy – Depending on inflation, the central bank raises or lowers the repo rate. As a result, it aims to control the economy by keeping inflation under control.

  • Hedging and Leveraging – The RBI intends to hedge and leverage by purchasing securities and bonds from banks and providing cash in exchange for the collateral deposited.

  • Short-Term Borrowing – The RBI lends money for a short period of time, up to an overnight period, after which the banks buy back their deposited securities at a predetermined price.

  • Collateral & Securities – The RBI accepts gold, bonds, and other forms of collateral.

  • Cash Reserve (or) Liquidity – As a precautionary measure, banks borrow money from the RBI to maintain liquidity or cash reserve.

What is Reverse Repo Rate?

The reverse repo rate is a mechanism that absorbs market liquidity, limiting investors' borrowing power.

When there is excess liquidity in the market, the RBI borrows money from banks at the reverse repo rate. Banks benefit from it by receiving interest on their central bank holdings.

  • When the economy is experiencing high levels of inflation, the RBI raises the reverse repo rate. 

  • It encourages banks to deposit more funds with the RBI in order to earn higher returns on surplus funds. Banks are left with fewer funds to lend and borrow to consumers. 

What Effect Does the Repo Rate & Reverse Repo Rate Have on the Economy?

A repo rate is a powerful tool in Indian monetary policy, with the ability to control the country's money supply, inflation levels, and liquidity.

Furthermore, repo levels have a direct impact on the cost of borrowing for banks. The greater the repo rate, the greater the cost of borrowing for banks, and vice versa.

Inflation is Rising

During periods of high inflation, the RBI makes concerted efforts to reduce the flow of money in the economy. One way to accomplish this is to increase the repo rate.

Borrowing becomes more expensive for businesses and industries as a result, slowing investment and money supply in the market. As a result, it has a negative impact on economic growth, which aids in the control of inflation.

Increasing Liquidity in the Market

When the RBI needs to inject funds into the system, it lowers the repo rate. As a result, borrowing money for various investment purposes becomes less expensive for businesses and industries. It also expands the economy's overall money supply. This, in turn, boosts the economy's growth rate.

Basically, when the RBI maintains the Repo Rate at a high level, banks tend to borrow less money from the central bank due to the high cost of funds. Notably, in tandem with the Repo Rate, the Reverse Repo Rate is also high. This encourages banks to keep more of their money with the RBI because the interest rate is higher.

Low-interest-rate regime: When the RBI keeps the repo rate low, banks can borrow more money from it at a lower cost. In the same vein, the Reverse Repo Rate is low in comparison to the Repo Rate. As a result, banks are hesitant to invest in the central bank because the returns are low.

Current Repo Rate and Its Effect

The RBI maintains the repo rate and the reverse repo rate in response to changing macroeconomic factors. When the RBI changes interest rates, it affects all sectors of the economy, albeit in different ways.

Some segments benefit from the rate increase, while others may suffer losses. The RBI recently reduced the repo rate by 25 basis points, lowering it from 5.75 percent to 5.15 percent. In the same vein, the reverse repo rate was reduced from 5.5 percent to 4.9 percent.

Changes in repo rates can have a direct impact on large-ticket loans such as home loans. The reduction in repo rates is intended to spur growth and improve the country's economic development. Consumers will borrow more from banks, bringing inflation under control.

A decrease in the repo rate may cause banks to lower their lending rates. This could be advantageous for retail loan borrowers. However, in order to reduce loan EMIs, the lender must lower its base lending rate.

According to RBI guidelines, banks/financial institutions must pass on the benefits of interest rate cuts to consumers as soon as possible.

Difference Between Repo Rate vs Bank Rate

The Repo Rate and the Bank Rate are the two most commonly used rates for commercial and central bank borrowing and lending. They are the interest rates at which the Reserve Bank of India lends money to commercial banks and other financial institutions.

While both rates are short-term tools used to control cash flow in the market and are frequently misunderstood as the same, there are some significant differences between the two.

The repo rate is the rate at which the RBI lends to commercial banks by purchasing securities, whereas the bank rate is the rate at which commercial banks can borrow from the RBI without putting up any security.

Conclusion

The monetary policies of various central banks around the world can have a variety of goals. In India, the primary goal of the Reserve Bank of India's Monetary and Credit Policy is to control inflation and keep it within a predetermined target range.