The Repo Rate (RR) is the interest rate at which the Reserve Bank of India (RBI) lends money to Indian commercial banks or financial institutions in exchange for government assets. To combat inflation, RBI’s monetary policy panel raised the key lending rate, also known as the repo rate, and interest rates by 35 basis point to 6.25% for the fourth time in a row, joining a long list of financial institutions and central banks that have done the same to combat the effects of a surging dollar and rising costs. Changes in the repo rate impact the movement of money in the market.
When the RBI lowers interest rates, it expands the economy by increasing the money supply. When interest rates are high, it stifles economic growth. The central bank, or RBI, and the commercial bank would agree to repurchase the securities at a predetermined price. This is done when banks are short on funds or need to maintain liquidity under volatile market conditions. Thus, RBI uses the repo rate to manage inflation.
This article delves into the repo rate definition, its importance, how it works, how the RBI repo rate affects the economy and more.
What is Repo Rate?
The full form of Repo Rate is “Repurchasing Option Rate.” The ‘Repurchasing Agreement’ is another name for it. In times of financial crisis, individuals obtain bank loans and pay the necessary interest. In the same way, commercial banks and other financial institutions also have trouble getting enough money. They can also borrow money from the central bank of the country. Any country’s central bank lends money to commercial banks at a fixed interest rate on the principal amount.
If a bank makes a loan against any type of security, the ROI is known as the repo rate. Commercial banks sell eligible securities to the RBI, such as treasury bills, gold, or bond papers. After the loan is paid back, the RBI will sell these securities back to the bank. As a result, it is known as the ‘Repurchasing Option’. If they take a loan without pledging the securities, the interest rate is the bank rate.
Importance of RBI Repo Rate
It is one of the RBI’s Monetary Policies. The RBI Governor presides over the Monetary Policy Committee’s(MPC) bimonthly meetings. It normally has six members. They collaborate to develop, manage, and alter policy rates. The RBI adjusts it based on the country’s liquidity situation or excess.
The following are the components of repo rate transactions between banks and the RBI:
- The RBI loans money to banks through a formal agreement that demands collateral. They could be bonds and securities. To lend money, the RBI hedges and leverages against bank securities.
- Short-term borrowings include RR loans and trades. Banks receive overnight or term funding, whilst the RBI holds securities.
- Banks can repurchase securities at a predetermined price and date. This is the loan amount, and the interest rate is determined at the RR.
- If banks default and fail to repay the funds on a certain date, the RBI is empowered to sell these instruments.
- Banks borrow money to make up for a lack of cash reserves. They occasionally borrow money to maintain the regulatory minimum reserve balance.
Current Repo Rate
The Monetary Policy Committee(MPC) agreed at its meeting, based on an assessment of the existing and evolving macroeconomic circumstances, to:
- The policy RR under the liquidity adjustment facility (LAF) is increased by 35 basis points to 6.25% with immediate effect. The marginal standing facility (MSF) rate, the bank rate, and the standing deposit facility (SDF) rate have all been lowered to 6.50% as a result.
- The MPC also decided to continue concentrating on removing accommodation in order to maintain inflation within target while fostering future growth. These steps are compatible with the objective of achieving the medium-term target of 4% CPI inflation within a +/-2% range while promoting growth.
How Repo Rate functions?
As stated above, the repo rate is used by the Indian central bank to control the market’s money supply. When inflation affects the market, the RBI hikes the RR.
As a result of an increase in the repo rate, banks that borrow money from the central bank during this period will be required to pay more interest. This prevents banks from borrowing money, so lowering the quantity of currency on the market and helping to combat inflation. However, repo rates are decreased in the event of a recession.
Repo Rate and Bank Rate: Similarities and differences
Both are effective RBI tools for monitoring economic activities and market liquidity. Nonetheless, the distinction between the two is the commitment of government securities to RBI for a loan. Below are a number of similarities and significant distinctions between the two:
Both affect liquidity and the pace of inflation. Banks and other financial organisations must pass on the benefits of interest rate reductions to their clients. Consequently, they must reduce the base rate.
The Base Rate (BR) is the lowest rate at which banks are permitted to lend to clients. RBI establishes this as the standard interest rate for all banks. When the Base Lending Rate(BLR) decreases, lending rates and monthly payments fall.
The distinctions between the two are:
- At bank rates, commercial banks and financial organisations obtain unsecured loans. In RR, securities are used as security for loans.
- The bank rate is typically higher than RR because the RBI provides unsecured loans through the former.
- Bank Rate loans are often longer-term, while RR loans are intended for the short term.
- Although changes in either rate may be passed on to commercial banks’ clients, the bank rate directly affects the lending rate. Banks may require time to adjust loan interest rates affected by a change in the repo rate. It is because the duration is shorter. Repo Rate typically influences expensive loans such as mortgages.
Repo Rate vs Reverse Repo Rate
Repo rates and reverse repo rates are utilised by central banks and other financial institutions to manage their daily short-term liquidity. The repo rate is the rate of interest at which commercial banks receive or borrow funds from the Reserve Bank of India. The RBI provides commercial banks with loans in exchange for government securities.
The reverse repo rate is the interest rate on deposits of commercial banks with the central bank. The majority of financial institutions chose this safer method to safeguard their funds in the case of a surplus. In other words, the reverse repo rate is the rate of interest paid on deposits.
The primary difference between the repo and reverse repo rates is that the RR generates income by lending to commercial banks, whereas the reverse repo rate generates income by earning interest on funds deposited with the Reserve Bank of India.
The reverse repo rate is used to manage the liquidity of the economy, while the repo rate is used to manage inflation. Central banks always keep the reverse repo rate below the RR.
Comparison of Repo Rate and Reverse Repo Rate
Reverse Repo Rate
The RBI is the lender, and the commercial bank is the borrower.
Commercial banks are the lender, while the Reserve Bank of India is the borrower.
The purpose of the RR is to control the shortfall of funds.
It is intended to diminish the overall money supply in the economy.
Repo rates offer a higher rate of interest than reverse repo rates.
The interest rate is inferior to the RR.
The repo rate’s relevant interest rate is determined by a repurchase agreement.
A reverse repurchase agreement determines the applicable interest rate.
The operation of the repo rate system for commercial banks uses government bonds as collateral to get cash from the RBI.
Under the reverse repo rate, commercial banks deposit their excess funds with the Reserve Bank of India and get interest on the deposits.
The higher the RR, the greater the cost of capital for commercial banks; consequently, loans become more expensive.
When the rate is high, commercial banks deposit more excess cash with the Reserve Bank of India, reducing the money supply.
Lowering the rate reduces the cost of financing for commercial banks and results in lower lending interest rates.
When the rate is low, the money supply in the economy increases as banks lend more and reduce their deposits with the Reserve Bank of India (RBI).
Effect of rate change
As discussed previously, even a small change in the repo rate can have a significant influence. RR affects the country’s credit availability, liquidity, inflation, and economic activity. When the financial system undergoes even the smallest shift, the economy can either flourish or suffer. Similarly, the economy must sometimes be depressed to stabilise inflation. The effects of a RR increase or decrease are as follows:
Impacts on inflation and economy
When the RR is high, banks are unwilling to lend in order to avoid paying excessive interest rates. Banks take steps not to exceed the cash reserve by reducing the loan grants. This hinders the movement of money and economic operations. In addition, it discourages inflation.
When the RBI reduces the rate, banks are able to borrow, spend, and invest more freely. More funds are available for investing purposes. The increased capital flow will result in accelerated company cycles and economic expansion.
Impact on bank loan rates
When the rate is high, banks must repay their loans to the Reserve Bank of India (RBI) at a higher interest rate. To compensate for this, they may charge a higher Rate of Interest (ROI) on loans to consumers. RBI discourages bank borrowing, while banks discourage customers. This drains the market of excess liquidity and so limits the inflation rate.
As the rate falls, banks may reduce their rates to attract more clients. Additionally, loan applications may be simplified for customers of commercial banks. It accelerates the demand for mortgages and other borrowing. While the customers receive financial aid at a cheaper interest rate, the banks profit. The economy flourishes as a result of a rapid money flow as the cost of funds declines.
In addition to loans, banks also modify the interest rates on fixed deposits (FDs) and savings accounts in accordance with the RR. It is an important benchmark against which banks establish all types of interest rates.
Thus, the RBI employs the repo rate as a measure to moderate inflation and maintain economic equilibrium. In the case of a rise or fall in inflationary pressures, the RBI adopts the opposite stance. RR increase aids in contracting the economy when price increases are escalating excessively. RR also stimulates the economy when the rate is low and the economy is cooling. It also increases or decreases the banks’ lending frequency and loan amounts. Loan rates similar to those for mortgages are sometimes RR linked lending rates. Therefore, it may fluctuate with the RR change.
Some market segments profit from the rate hike, while others are harmed by it. This article was created to educate readers about the potential effects of this increase on many economic sectors. Thus, one should manage their funds with caution.
1. When is the Repo Rate determined?
Ans: The Monetary Policy Committee of the RBI determines the RR every two months.
2. What links the Repo Rate to inflation?
Ans: A repo rate is a tool used by the Indian central bank to regulate the amount of money available on the domestic market. The ability of commercial banks to borrow lessens with a higher repo rate, which in turn reduces the amount of currency flowing through the market system. This method helps to keep inflation under control.
3. The Repo Rate is decided by whom?
Ans: The RR is decided by the Monetary Policy Committee (MPC), which is presided over by the governor of the RBI.
4. What is the meaning of Repo Rate?
Ans: The RR is the interest rate at which the Reserve Bank of India (RBI) lends money to Indian commercial banks or financial institutions in exchange for government assets.