Repo rate and Reverse repo rate: Meaning and Impact on economy

Repo Rate

Repo is a short-term money market instrument that is used to raise capital for the shorter-term. In Indian Banking terms, the repo rate is the rate at which Reserve Bank of India lends money to all the commercial banks in the country in the event of scarcity of funds. The repurchase agreement is signed by both parties involved in the transaction. The current rate is 5.75%.

The 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 lend/deposit 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 the banking system. Banks are left with lesser cash to extend loans, curbing the purchasing power of individuals.

How does Repo Rate work?

When you borrow money from the bank, they charge interest on the principal. It is the cost of credit. Similarly, banks too can borrow money from RBI during cash crunch on which they must pay interest to the Central Bank. This interest rate is the 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 transactions as well.

Components of a Repo transaction

The components of a repo transaction between the RBI and the bank are as follows:

• Banks provide eligible securities (RBI-recognized securities that are above the Statutory Liquidity Ratio limit).
• RBI gives 1 day or overnight loan to the bank.
• RBI charges interest from the bank.
• Banks repay the loan after one day and repurchase the security they gave as collateral.

How does Repo Rate affect the economy?

It is a powerful arm of the Indian monetary policy that can regulate a 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 rate, the higher will be the cost of borrowing for banks and vice-versa.

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 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.

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 the 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.

Significance of Repo Rate & Reverse Repo Rate

Liquidity Regulator:

Under the liquidity framework designed by RBI, many facilities are offered to commercial banks to meet their requirement of immediate liquidity or deficiency of funds. The main motive of the liquidity framework is to avoid any liquidity crisis in the Indian banking system. This popular system of liquidity framework is generally known as a repo.

Similarly, the RBI has a framework for surplus funds/cash in the banking system which ensures there is no excess liquidity in the system. And this framework is referred to as reverse repo. Repo transactions inject liquidity into the Indian banking system. On the other hand, reverse repo absorbs liquidity from the Indian banking system.

Price Stability:

RBI has to control the rate of inflation and stimulate economic growth and strike a balance between both inflation and economic growth by revising the repo rate on a half-yearly or quarterly basis. It is important for the country’s economic growth. And it’s equally important to avoid the higher rate of inflation in the country. This is where repo rate and reverse repo plays a crucial role by helping the RBI strike a balance between both inflation and economic growth.

Impact of Repo Rate

The Repo Rate can cause a range of effects on the overall economy whether it is an impact on the banking sector, an impact on the average citizen or some other aspect of the Indian economy. The following are some short descriptions of the same.

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.  Banks may analyze their liquidity position and cost of funds before increasing the deposit rates and lending rates. After analyzing 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. Home loans, business loans, and other 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.
• Reduction in Repo Rate: Banking is the first sector to get affected by any change in monetary policies. It’s a big relief to the bank when the RBI decides to reduce the repo rate. With the dip in repo rate, banks can borrow from RBI at a cheaper rate. With the accessibility of low-cost credit, banks may even reduce the lending rates to their customers after analyzing the liquidity condition and the deposit inflows. Banks may offer credit to its end customer at a reduced rate. As bank loans get cheaper, consumers can spend and borrow more while spending a lot less on borrowing.

Impact on the Common Man

• Increase in Repo rate: When RBI decides to hike the repo rate; it becomes costlier for commercial banks to borrow short term funds from RBI. Increased repo rate discourages the bank from availing short-term loans and advances from RBI. 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 an increased rate to attract more inflow of funds. It helps the consumer to save more with the increased rate on bank deposits.

You can also read: Liquid Funds vs Fixed deposits

• Reduction in rate: When RBI decides to reduce the repo rate, loans and advances become cheaper for the commercial banks as they can avail short-term credit from RBI at the reduced rate. General consumers have more investment options. The rate cut may push banks to reduce their home and personal loan rates. Reduction in prime lending rate encourages more borrowers by making credit accessible at lower rates to the common man.

Impact on the Economy

• Increase in Rate: When RBI hikes 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 RBI. 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. Hence, the RBI revises the repo rate regularly 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 the increase in repo rate on the economy.
• Reduction in Rate: When RBI decides to cut the repo rate, the short-term loans for commercial banks become cheaper. This prompts them to offer consumer loans at a relatively cheaper rate. Many times, the base lending rate gets reduced with the reduction in the repo rate. The base lending rate is the rate below which banks cannot lend to their 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. Cheaper availability of credit encourages businesses to grow and expand. Prices of products get lower with the availability of low-cost capital.

Current Rates

RBI keeps changing these rates according to changing macroeconomic factors. Whenever RBI modifies the rates, it impacts every sector of the economy. Some segments gain as a result of the rate hike while others may suffer losses. RBI recently cuts the repo rate by 25 basis points to 5.75% and the reverse repo rate to 5.50%.

GDP growth plunged to a five-year low of 5.8 percent in the January-March quarter due to slow growth in agriculture, manufacturing, construction, trade, hotels and power sectors. This, in turn, pulled down the FY19 GDP growth rate to a five-year low of 6.8 percent.

This blog on Repo Rate was to make you aware of the concept, impact, and importance of Repo Rate for the economy. Our company WealthBucket is a CA/CS Firm providing various services related to Mutual Funds like investing in Large Cap Mutual funds, Equity Funds, Debt Funds, etc.

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