- What is Repo Rate?
- Current Repo Rate and Change History in India
- How Does the Repurchasing Option Rate Work?
- RBI Repo Rate Policy
- Components of Repo Transactions
- What is Reverse Repo Rate?
- Similarities Between Repo Rate and Reverse Repo Rate
- Repo Rate vs Reverse Repo Rate- What is the Difference?
- What is the Bank Rate?
- Bank Rate vs Repo Rate- What is the Difference?
Repo Rates influence our economy largely. It is the rate of interest at which the RBI lends money to commercial banks or financial institutions. It lends the money against government securities. The changes in Repo Rates affect the economy by controlling the cash that moves through it. RBI slashes the rates to supply more money to the economy. When the repo rate goes up it slows down the economy. The current repo rate announced by MPC (Monetary Policy Council) of RBI on 4 December 2023 is 6.50%.
What is Repo Rate?
The full form of ‘REPO’ Rate is ‘Repurchasing Option’ Rates and it is also known as a ‘Repurchase Agreement’. In times of financial difficulty, banks and financial institutions need loans and pay interest against the funds.
RBI being the apex bank of the country lends funds to commercial banks after they pledge their securities. Commercial banks sell their securities such as gold, treasury bills, or bonds to RBI. They repurchase these securities after repaying the loan. It is also the rate of interest at which RBI lends funds to the banks against their securities.
The monetary policy council sets the repo rate and influences economic activity through it. Repurchasing Option rate impacts liquidity in the economy by determining the rise or drop of the money supply. In turn, these changes drive the retail lending policies of commercial banks. It changes the rate of interest on home loans, bank deposits, and retail loans.
Current Repo Rate and Change History in India
|Date||RBI Repo Rate|
|08-02-2023 to Till Today||6.50%|
How Does the Repurchasing Option Rate Work?
Commercial banks in India borrow money from the RBI similar to how you borrow funds from banks. The interest applicable to the principal amount is known as the cost of credit. Banks pay interest against the amount you borrow. It is the rate at which RBI charges interest.
It is a crucial benchmark for the economy and makes the lending market more competitive. A high Repurchasing Option rate restricts economic activity as banks tend to borrow less money from RBI. If it is low then banks borrow more funds and it increases liquidity in the economy.
How Does the it Affect an Economy?
This is a powerful instrument of Indian monetary policy. It regulates the cost for credit i.e. the rate of interest a bank levies on the money it lends. Overall, the rates impact money supply, liquidity, and inflation levels in the country. The main effects on the economy are:
- Increasing it helps curb inflation– When inflation is rising RBI increases the repo rate to make borrowing costly. Though it negatively impacts the growth of the economy, it helps in controlling inflation.
- Decreasing it boosts liquidity– RBI lowers the repo rate to pump funds into the economy. Consequently, borrowing money becomes cheaper as the overall supply of money in the economy increases.
RBI Repo Rate Policy
The responsibility of conducting the monetary policy rests with the Reserve Bank of India. It specifies the objective to maintain monetary stability in the economy while ensuring its growth. The policy allows RBI to keep inflation and growth under control. Based on an assessment of the current and evolving macroeconomic situation RBI announces the repo rate. Changes in it influence aggregate demand. Market rate fluctuations due to the repo rate transmit across the financial system and improve the country’s economic condition.
Components of Repo Transactions
The following are the components of repo transactions. These are the factors depending on which the RBI approves a repo transaction with a bank.
- Collaterals and Securities- The collaterals and securities offered by the applying bank to the RBI such as treasury bills, government bonds, gold, and other securities.
- Controlling Inflation- Depending on inflation, the central bank raises or lowers the Repo rate. As a result, it seeks to govern the economy by limiting inflation.
- Hedge and Leverage- The RBI intends to hedge and leverage by purchasing assets and bonds from banks and providing cash in exchange for collateral.
- Short Term Funds- The RBI lends money for a brief time, up to an overnight period. After this period the banks purchase back their securities deposited at a predetermined price.
- Cash Reserve Ratio- Most banks borrow from RBI to maintain the mandatory level of the cash reserve ratio.
What is Reverse Repo Rate?
The Reverse Repo Rate is a tool for absorbing market liquidity and limiting investors’ borrowing capacity. When there is excess liquidity in the market, the RBI borrows money from banks at a reverse repo rate. The reverse repo rate is the repurchasing agreement pledged by the RBI. Banks benefit from it because they receive interest on their central bank holdings.
The RBI raises the reverse repo when the economy is experiencing high inflation. It encourages banks to deposit more money with the RBI in order to earn higher interest on their surplus money. As a result, banks are left with lower liquidity to issue consumer loans and borrowings. In other words, the RBI pays these banks to deposit their funds with the RBI.
With a higher reverse repo rate, the banks earn higher interest by depositing their surplus with RBI than lending to their customers. Usually, banks opt for this option over lending to customers because it provides higher interest income, safer option, and is backed by government securities.
Moreover, a lower reverse repo rate is a demotivation for banks to deposit with RBI. Now lending to customers seems to be an attractive option for accruing interest and gaining profits.
Similarities Between Repo Rate and Reverse Repo Rate
- RBI provides RR loans to banks, while banks provide RBI with Reverse Repo Rate loans.
- Both demand security or pledges as collateral in the form of bonds, bills, instruments, or securities. In order to avail of a loan with a repo rate, banks issue security to RBI. The RBI, on the other hand, offers securities in exchange for loans with Reverse Repo rates.
- Both are a key mechanisms for controlling inflation. The reverse repo rate and repo rate are included in the LAF (Liquidity Adjustment Facility).
- The Repo Rate determines the Reverse Repo Rate. Because the spread between the two represents the RBI’s income, RRR is always lower than RR. Also, loan interest rates are higher than deposit rates. However, both of these rates are frequently in sync. RBI tries to change them while keeping them in agreement.
Repo Rate vs Reverse Repo Rate- What is the Difference?
|Repo Rate||Reverse Repo Rate|
|Rate at which the RBI lends to banks in the nation||Rate at which RBI borrows from the banks (public and private)|
|Lending rate is higher than borrowing rate i.e. reverse repo rate||Reverse repo rate is less than repo rate|
|Mechanism to control and manage inflation in the country||Tool to manage cash flow and lending|
|Involves selling of securities and repurchase on a later date||A transfer to funds from one account to another just like any other lending and borrowing|
What is the Bank Rate?
The “Bank Rate” is the interest rate charged by the central bank on loans provided to commercial banks and other financial institutions. There is no formal repurchase agreement, no securities sold, and no collateral in this case. Banks borrow money from the central bank and then lend it to their customers at a higher interest rate. This way the commercial banks make a profit between the borrowing rate from RBI and the lending rate to customers. When the RBI raises the Bank Rate, banks’ borrowing costs rise, reducing the amount of money available in the market.
Bank Rate vs Repo Rate- What is the Difference?
|Bank Rate||Repo Rate|
|A commercial bank repays the loan along with interest to RBi||The borrowing bank agrees to repurchase the securities under the Repurchasing option at the REPO rate|
|A long term borrowing alternative for banks. It directly impacts the lending rates in the country||A short term borrowing option ranges from overnight to 1 day. It affects the liquidity in the monetary market.|
|Direct and impactful effect on the interest rate||No direct impact on the interest rate.|
|Higher than the repo rate due to long term borrowing intent||Lower than the bank rate.|
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