Reverse Repo Rate (RRR) is an RBI policy tool. ‘REPO’ itself stands for ‘Repurchase Option’. The Reverse Repo Rate is the rate at which banks lend money to RBI as a loan or rather as a deposit in RBI. RBI pledges collateral of government securities and banks park their excess funds at RBI. RBI pays the banks the interest at Reverse Repo Rate to have account deposits and buy back these securities when the tenure of the Reverse Repo Rate ends. The Current Reverse Repo Rate is 3.75%. RBI sets the Reverse Repo Rate in India as per the Monetary Policy of the country.
Reverse Repo Rate Definition & Concept
Reverse Repo Rate is a tool of RBI to absorb or exude liquidity which means the cash flow in the market. When there are superfluous funds in the banks, it enhances the money supply in the market. Oversupply can lead to inflation and hence, RBI tries to keep it in check. Reverse Repo Rate is a part of the Liquidity Adjustment Policy or LAF. LAF is a monetary policy wherein banks can lend and borrow money on the basis of Repurchase Agreements. The Reverse Repo Rate is meant for the short term, either for 7 days or 14 days.
Reverse Repo Rate Meaning – Understanding the Terminology
It is termed as Reverse Repo Rate because it is the reverse of Repo Rate. Repo Rate implies that banks can borrow money from RBI during a shortage of funds. RBI lends money to banks at higher interest when it wants to discourage lending and control inflation. On the other hand, RBI borrows from banks at Reverse Repo Rate. RBI imposes a higher Reverse Repo Rate when it wants to control lending and liquidity. Both are repurchasing agreements as there is the involvement of security provisions. RBI pledges securities to banks at Reverse Repo Rate and vice-versa in case of Repo Rate.
Why Reverse Repo Rate Lower than Repo Rate?
Reverse Repo Rate is lower than Repo Rate because of the simple reason that loans attract higher interest than deposits. Individuals usually pay higher interest on loans than what they earn through savings or current deposits. Although fixed deposits and recurring deposits have good returns, they are meant for long-term investments. Similarly, RBI grants loans at Repo Rate and receives loans as deposits at Reverse Repo Rate. Thus, Repo Rate is higher than Reverse Repo Rate. The money earned between lending at a higher rate and borrowing at a lesser rate is also the profit-making mechanism of RBI. This also encourages lending as banks will lend more to customers to attract higher interest than earn less from RBI.
Importance of Reverse Repo Rate
The importance of Reverse Repo Rate is that RBI assures that there is neither excessive cash flow nor lack of it. The Reverse Repo Rate is increased or decreased accordingly. The impact, in either case, is as such:
1. Impact on Economy and Inflation
When RBI fears inflation due to surplus funds in the banks, it increases the Reverse Repo Rate. It attracts the banks to have deposits in RBI for higher interest. Banks find it secure enough to lend to RBI against government securities than to lend to people. It is to put a brake on the lending intentions of the banks to business investments and the customers. This impeded the cash flow and sabotage the inflation
When RBI observes that the economy may slow down due to less cash flow, it decreases the Reverse Repo Rate. This is because banks may not want to have a deposit to earn fewer profits when they have the option to earn more from lending loans. This will expedite the loan lending process for bank customers. Thereby, the cash flow will improve speeding the economic activities
2. Impact on Bank Rates
The bank loan interest rates may also differ according to the changes in Reverse Repo Rate. Interest rates of bank loans may fall when Reverse Repo Rate is cut off because banks will lend more. Rates of interest/ROIs of loans may rise when Reverse Repo Rate is high as there will be less supply of loans as compared to customers’ demand. Also, banks will like to lend only if they accrue higher interest and profit from loans. It is because they will have a more secure alternative to earn interests from deposits in RBI
3. Impact on Currency
It impacts the value and the strength of the currency. When the Reverse Repo Rate is high, it means banks have more money parked with RBI than lent out in the markets. The less supply of money boosts the strength of the Rupee
Also Read: Repo Rate vs Reverse Repo Rate
Wrapping it up
The Reverse Repo Rate plays an important role in the financial system and economy of the country. RBI modifies the rates as and when required to keep a check on inflation. RBI Reverse Repo Rate is 3.35% and it has continuously lowered RRR in order to promote lending. The economic activities suffered a setback during the pandemic because of slowed cash flow. RBI has continuously slashed the rates to the current Reverse Repo Rate today to put things back in place.
- As mentioned in the article above, the impact of the Reverse Repo Rate is on liquidity which in turn controls inflation. If decreased, it stokes up the money flow & vice-versa.
- Home loans may get expensive if the Reverse Repo Rate is high. Lending rates of banks alter if the base rate changes which is after the effect of RRR changes.