Understanding Repo Rate And Reverse Repo Rate

Reserve Bank of India formulates the monetary policies and executes them to achieve a few specific objectives. Monetary policy refers to the policies formulated for the purpose of controlling monetary supply and rate of interest/cost of money in the economy to stimulate the growth. The primary objective of such monetary policies are promoting economic development through price stability, regulation of the volume of bank credits, improving efficiency of the financial system, promoting investments and reducing the rigidity to encourage diversification etc. Repo rate and reverse repo rate are the key instruments of monetary policy of India that are used to control money supply in the economy.

Repo Rate: The term ‘Repo’ stands for ‘Repurchase agreement’. Repo is form of short-term, interest-bearing and collateral-backed borrowing. Interest rate for such borrowings is termed as repo rate. Repo is basically a short-term money market instrument which is used to raise capital for the shorter-term. In Indian Banking terms, 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. In other words, it is the rate at which Commercial Banks sell their securities and bonds to Reserve Bank of India with an agreement to repurchase the securities and bonds from Reserve Bank of India on a future date at a pre-determined price. The repurchase agreement is signed by both parties involved in the transaction. Current repo rate is 6.25%.

Reverse Repo Rate: Reverse repo is an opposite contract to the Repo Rate. Reverse Repo rate is the rate at which Reserve Bank of India borrows funds from all the other commercial banks in the country. In other words, it is the rate at which commercial banks in India park their excess money with Reserve Bank of India for a short-term period. Current reverse repo rate is calculated at 6%.

IMPORTANTCE OF REPO AND REVERSE REPO RATE

• Repo and reverse repo are the monetary measures used by the Reserve Bank of India to deal with the deficiency of funds and liquidity in the market. It is one of the vital money control mechanisms used by the central bank of the country.
• Bank lending and investment rates are decided based on the repo rate and reverse repo rate.
• Repo and reverse repo are the most effective and efficient tools used by the Reserve Bank of India to achieve price stability and to boost economic development.
• Repo rate and reverse repo rate are among the most crucial monetary policy instruments available to the RBI.
• There is considerable rise in borrowing by commercial banks through repo route which makes it an important element of India’s monetary policy framework. The constant nature of the balance between Repo and Reverse-Repo makes it more powerful in the Indian banking system.

SIGNIFICANCE

• Liquidity Regulator: Under the liquidity framework designed by Reserve Bank of India, 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 repo. In the similar way, Reserve Bank of India 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. Basically, repo transactions inject liquidity into the Indian banking system. On the other hand, reverse repo absorbs liquidity from the Indian banking system.
• Price Stability: Reserve Bank of India has to control the rate of inflation and stimulate the 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 Reserve Bank of India strike a balance between both inflation and economic growth.

IMPACT

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. 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 cheaper 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 cheaper, 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.

Impact on the Common Man

• 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 cheaper 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.

Effects of Reverse Repo Rate

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 a hike 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.

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.

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. Recently, Reserve Bank of India has increased reverse repo rate by 25 basis points, from the earlier rate of 5.75 to 6 percent at present. However this is not expected to have any major impact on retail customer borrowings in the recent future. With the increased reverse repo rate supply of money in the market will reduce. Due to reduced money supply, inflation rate is expected to get reduced.