Repo Rate and Reverse Repo Rate

Repo Rate

Repo rate is also known as Repurchase Rate.

Repo stands for Repurchase Agreement.
Repo rate is an interest charged on repo which is a form of short-term collateral backed borrowing instrument.

Reserve Bank of India (RBI) lends money at Repo Rate to the commercial banks if they feel scarcity of funds in the bank or in the market.

Commercial Banks sell Government securities and bonds to Reserve Bank of India (RBI) with an agreement to repurchase the security and bonds from Reserve Bank of India (RBI) on a future date at a predetermined price including interest charges.

It is the primary tool in the RBI’s Monetary and Credit Policy.
It is the key monetary policy to control credit availability information and economic growth.

Repo Rate influence-

  • Interest Rate at which common man will get loan.
  • And return common man will get on his deposits.

Bank adjust saving account, fixed deposit return based on this Repo Rate.

Types of lending and borrowing under Repo Rate-

1. Overnight Repo:-

A Repo transaction for day is known as Overnight Repo. In this banks sell securities to the RBI (Reserve Bank of India) for money and repurchases those the following day and return the money to the Reserve Bank of India (RBI).

2. Term Repo-

It includes a period of more than one day. The usual duration of term Repo or variable rate term is 7 days, 14 days and 28 days. Central Bank normally announces this term Repo auction as and when there is a need of funds by the bank for a duration of more than one day.

Reverse Repo Rate-

Reverse repo Rate is the rate at which the central bank that is RBI borrows fund from the commercial banks in the country.
It is the rate at which Commercial Banks in India invest their excess money with RBI for short term.
It is the important monetary policy tools used by the RBI (Reserve Bank of India) to control liquidity and inflation in the economy.
It helps the RBI to get money from the banks and in return RBI offer attractive interest rate to the commercial banks.

How Repo Rate and Reverse Repo Rate are used to control inflation, money supply and economic growth?

1. High rate regime:

When the Repo Rate is kept high, banks tend to borrow less money from the central bank due to the high cost of funds. Notably, the Reverse Repo Rate is also high in tandem with the Repo Rate. This incentivizes banks to keep more of their money with the RBI instead of borrowing money from RBI, due to higher income on it.

2. Low rate regime:

When the Repo Rate is kept low, banks can borrow more money from it at low cost. In the same vein, the Reverse Repo Rate is also low in line with the Repo Rate. Thus, the banks are inclined to put less money into the central bank, as it would fetch lower returns.

How Repo Rate and Reverse Repo Rate controls inflation and growth?

High Repo Rate and Reverse Repo Rate leave less money available with banks to lend, and vice versa. Credit is the backbone of a capital-led economy. Less availability of loans due to the high costs of borrowing restricts money supply for furthering economic activity. This comes in handy when the inflation is high by RBI’s target standards, and there is a need to rein in the rise in prices to check overheating in the economy. Often, this comes at the cost of some economic growth.

On the other hand, when the inflation is well under control, and economic growth is cooling off a bit too much, RBI may want to cut Repo Rate and Reverse Repo Rate. This is aimed at increasing credit availability and reducing the cost of borrowing, leaving more money in the hands of entrepreneurs and businesses to fuel economic activity.

Who decides Repo and Reverse Repo Rate in India?

In India, the current Repo and Reverse Repo Rate is decided by the RBI’s Monetary Policy Committee (MPC) which is headed by the RBI Governor.

Effects of Repo Rate-

1. It’s Impact on the Banking System

Increase in Repo Rate:

Lending rates and deposits offered by banks are impacted by a rise or fall of repo rate. However, it may not have an immediate effect. Banks may analyse their liquidity position and cost of funds before increasing the deposit rates and the lending rates.
After analysing the cost of funds and liquidity position, banks may begin to pass on their interest rate burden to its end customer in the form of elevated lending rates. That means higher equated monthly instalment for existing borrowers and higher rate of credit for new borrowers.
Home loans and other floating rate loans get majorly affected due to rate change. Higher lending rates may lead to a slowdown of the lending business for the banking sector, which will have an impact on their profitability.
Post analysis of liquidity position, banks may also hike the rate of bank deposit offered to customers to attract more inflow of funds into the banking system.

Reduction in Repo Rate:

Banking is the first sector to get affected by any change in monetary policies. It’s a big relief to bank when Reserve Bank of India decides to reduce the repo rate. With the dip in repo rate, banks can borrow from Reserve Bank of India at a affordable rate.
With the accessibility of low cost credit, banks may even reduce the lending rates to its customer after analysing the liquidity condition and the deposit inflows. Banks may offer credit to its end customer at a reduced rate.
As bank loans get affordable, consumers can spend and borrow more while spending a lot less in borrowing. Increased lending business will boost the profitability of the overall banking system.
However, lending rate cut and deposit rate hikes are purely dependant on the bank’s liquidity position and deposit demand from customers.

2. It’s Impact on An Individual

Increase in Repo rate:

When Reserve Bank of India decides to hike the repo rate; it becomes costlier for commercial banks to borrow short term funds from Reserve Bank of India. Increased repo rate discourages the bank from availing short-term loans and advances from RBI.
Due to non availability of low cost funds, banks my hike the lending rate for its customers to pass on its high interest burden. That means loan becomes costlier for a common man. This may automatically reduce consumer purchasing power.
On the other hand, banks may begin to offer fixed deposits at increased rate to attract more inflow of funds. It basically helps consumer to save more with increased rate on bank deposits.

Reduction in Repo rate:

When Reserve Bank of India decides to reduce the repo rate, loans and advances become affordable for the commercial banks as they can avail short-term credit from Reserve Bank of India at the reduced rate.
Rate cut may push banks to reduce their prime lending rate. Reduction in prime lending rate encourages more borrowers by making credit accessible at lower rates to the common man.
With the increased opportunity to borrow, consumer can spend more and avail loans to achieve future financial goals easily. One should understand the repo rates to manage their finances in a better way.

3. It’s Impact on the Economy

Increase in Repo Rate :

When Reserve Bank of India increases repo rates, it becomes costlier for banks to borrow. In other words, banks will have to pay more interest on their short-term borrowings from the Reserve Bank of India. Costlier credit option for banks prompts them to hike the lending rate which they offer to their end customers.
Expensive bank loans discourage the borrower from availing credit. This reduces the money supply in the market and thereby stabilizes the liquidity in the system. Consumption, Expansion and production also take a downfall with the lesser money supply. Expensive credit hinders economic development and GDP growth even though inflation rate comes under control.
Hence, Reserve Bank of India revises repo rate on a regular basis to keep the inflation rate under control and also to strike a balance between both economic growth and rising inflation.
Here are some of the vital impacts of increase in repo rate on economy:

Borrowing becomes costlier for banks as they avail short-term credit from Reserve Bank of India at relatively higher rate. With the costlier credit for banks, they will ultimately lend the consumers at relatively increased rate. This may lead to costlier bank loans for customers. As the lending get expensive, borrower gets discouraged and demand for bank loan reduces.
Reduced borrowing results in lower consumption demand which will lead to economic slowdown that hinders the growth of GDP for the short term. As the consumption demand reduces, profitability of every sector in the economic system takes a hit.
Corporate loan buyers get discouraged to avail credit with the hike in repo rate also discourages the. As the availability of business capital becomes expensive, production and expansion plans of corporate take a backstop.
Increase in repo rate reduces the money supply in the economic system and thereby reduces the rate of inflation.

Reduction in Repo Rate :

When Reserve Bank of India decides to cut the repo rate, the short-term loans for commercial banks become affordable. This prompts them to offer consumer loans at a relatively discount rate. Many a times, base lending rate gets reduced with the reduction in repo rate.
Base lending rate is the rate below which banks cannot lend to its customers. Reduced base rate increases the consumption as people will have more money at their disposal. Increased consumption positively impacts the country’s Gross Domestic Product (GDP) growth.
Affordable availability of credit encourages businesses to grow and expand. Prices of products get lower with the availability of low cost capital. New investments lead to better employment opportunity in the economy.

Here are some of the key impacts of repo rate cut on economy :

Consumption Demand :

Demand for auto, housing and every sector will rise due to availability of affordable bank loans to customer. Economic growth will take a upward trend with its every sector growing due to increased consumption demand.
Economic activities picks up: With the falling prices, economy grows at a slower rate. Repo rate cut boosts the economic activities and prompts healthy growth with adequate supply of money in the market.
Boost to foreign investments: Bank lending rates get reduced with the cut in repo rate. Lower borrowing rates will encourage the foreign players to investment in Indian financial market.
It is important to note that the repo rate cut is not the only monetary measure for economic growth.

Effects of Reverse Repo Rate

1. Its impact on Banking System

Increase in Reverse Repo Rate :

Whenever there is excessive money floating in the banking system, Reserve Bank of India decides to increase the reverse repo rate.
When there is an increase in reverse repo rate, banks can earn higher interest on their excess funds lent to the Reserve Bank of India.
This is a safe investment option for the banks also. With banks earning more on their investments, automatically it will have a positive impact on the profitability of banking business.

Reduction in Reverse Repo Rate :

Whenever Reserve Bank of India decides to reduce the reverse repo rate; banks cannot earn more on the money lent to Reserve Bank of India.
There will not be any positive impact on profitability of banking business with the reduced rate.

2. It’s impact on Common Man

Increase in Reverse Repo Rate :

Soaring inflation is always a concern for common of the country. Essential commodities and basic food items get costlier with the rising rate of inflation.
RBI sucks the surplus money in the financial system by increasing the reverse repo rate. With the increased reverse repo rate, more and more banks will start supplying excessive funds to Reserve Bank of India.
This will reduce the money supply in the financial market. Due to reduced money supply in the market, inflation will also come down. Increased reverse repo rate helps common man by curbing the rate of inflation.

Reduction in Reverse Repo Rate :

With the lesser investment options available to banks due to reduced reverse repo rate, banks earning on investment will reduce.
This gradually increases the supply of money in the market which causes inflation to rise. Rising inflation affects the life of common man.

3. It’s impact on the Economy

Reserve Bank of India increases the reverse repo rate with the objective to flush out the excess liquidity in the financial system by keeping check on inflation rate.
The most important effect of Reverse Repo Rate is in the reduction of inflation. For quite some time, the control of inflation has taken centre stage in India’s monetary policy. When Reserve Bank wants to tighten credit, it increases the Reverse Repo Rate.
When reverse repo rate is increased by Central Bank, it attracts deposit of funds by commercial banks leaving less money with the banks for lending activities. Due to reduced funds availability in case of less liquidity, banks increase their lending rates.
As a result, consumers are left with the only choice of costlier borrowing from banks. As a result borrowing is discouraged and people are left with less disposable money and less buying opportunity.
This will cause an imbalance between supply and demand of commodities in the market. With more items/services offered and less customers to avail those, the businessmen will be forced to lower the prices of their product. This will lead to lowering of inflation.
Variation in Repo rate and Reverse Repo Rate can have significant influence on the applicable interest rates of various banking products like mortgages as well as different types of loans and savings.

Why is Repo Rate higher than Reverse Repo Rate?

Banks can invest excess money with the RBI at a lower interest rate than the Repo Rate or Repurchase Rate. The Reverse Repo Rate is lower than the Repo Rate. The spread between the two is the RBI’s income. RBI earns more on what it lends to banks than its expense on what it borrows from the banks. Since RBI can’t offer higher interest on deposits and charge lower interest on loans, Repo Rate is higher than Reverse Repo. Also, the Reverse Repo Rate is generally kept lower to discourage banks from keeping surplus funds with RBI as against lending them to individuals and businesses. Both the primary tools in RBI’s Monetary and Credit Policy work in an opposite manner.

Reverse Repo Rate impacts the strength of rupee/currency?

Higher Reverse Repo Rate reduces the money supply in the market as the banks park their surplus cash with the RBI to earn attractive returns as against lending to individuals and businesses. It reduces the supply of money in the system, thereby boosting the strength of the rupee.

The Reserve Bank of India on 22nd May,2020, lowered the repo rate by 40 basis points to 4%. The reverse repo rate has also been reduced to 3.35%.

Source- Wikipedia, The Economic Times, The Hindu.

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