Repo Rate (RR) is the rate at which the Reserve Bank of India (RBI) lends money to commercial banks or financial institutions in India against government securities. The current Repo Rate 2021 is at 4%. Changes in Repo Rate affect the flow of money in the market. When RBI slashes the rates, it expands the economy by fuelling the money supply. It restricts economic growth when rates are high. This article discusses in detail the Repo Rate definition, how it works, and how the RBI Repo Rate (RR) today influences the economy.
What is the meaning of Repo Rate?
Repo Rate full form is or the term ‘REPO’ stands for ‘Repurchasing Option’ Rate. It is also known as the ‘Repurchasing Agreement’. People take loans from banks in times of financial crunch and pay interest for the same. Similarly, commercial banks and financial institutions also face a shortage of funds. They can also borrow money from the country’s apex bank. The Central Bank of any nation lends money to commercial banks at an interest rate on the principal amount.
If banks take a loan against any kind of security, then this ROI is Repo Rate. Commercial banks sell off eligible securities such as treasury bills, gold, or bond papers to RBI. Banks can repurchase these securities from RBI later when they repay the loan. Hence, it is called the ‘Repurchasing Option’. If they take a loan without pledging the securities, it is at the Bank Rate.
Similarities & Dissimilarities between Repo Rate and Bank Rate
Both are powerful tools of RBI to keep a check on economic activities and money flow in the market. However, the pledge of government securities to RBI for a loan is what marks the difference between the two. Below are some similarities and major differences between the two:
Both influence liquidity and check the inflation rate. Banks & financial institutions need to transfer the benefits of interest rate cuts to customers. Due to this, they have to lower down the Base Rate. Base Rate is the minimum rate at which banks can lend to customers. This is the standard interest rate for all banks and RBI sets it. When the Base Lending Rate reduces, loans are available at cheaper rates and lower EMIs.
The differences between the two:
- At Bank Rate, commercial banks and financial institutions borrow money without any security. In Repo Rate, securities serve as collateral for loans
- Bank Rate is usually higher than RR as in the case of the former, the RBI lends loans without security
- Loans at Bank Rate are usually given for longer-term while it is meant for the short term when lent at Repo Rate
- Although changes in either of the rates may pass on to the commercial banks’ customers, Bank Rate influences the loan rate directly. Banks may take time to change the loan interest rates subject to Repo Rate change. It is because it is for a shorter duration. Repo Rate usually impacts the big-ticket loans such as home loans
Importance of RBI Repo Rate
It is one of the ‘s Monetary Policies of RBI. The RBI Governor presides over the bi-monthly meetings of the Monetary Policy Committee (MPC). It usually consists of 6 members. They together formulate, administer and modify the policy rates. The RBI changes it according to the liquidity crunch or surplus in the country. There are certain components of RR transaction between banks and the RBI as below:
- RBI lends money in a legal agreement with the banks that requires collateral. It can be securities and bonds. RBI hedges and leverages against securities from banks to lend monetary help
- RR loans or transactions count as short-term borrowings. Banks get overnight or term funds while the RBI has the securities
- Banks can repurchase securities on a specified date and at a predetermined price. This price is the loan amount and the interest amount is calculated on it at the RR
- RBI is authorized to sell these securities if banks turn defaulters and fail to repay the cash on a predetermined date
- Banks borrow money to deal with a deficiency of cash reserves. Sometimes, they borrow money to maintain the minimum reserve balance as a statutory measure
How RR Functions?
Banks take loans from RBI pledging securities and repurchase them the following day. The loan is an overnight fund for banks undergoing a cash crunch. Although the loan at RR is usually for 1 day, banks may need it for more than a day. The one-day loan is at Overnight Repo while more than that is a Term Repo. Term Repo is also called Variable Rate Term Repo. RBI normally announces auction for Term Repo as it can be for 7, 14, or 28 days. When inflation is higher than RBI’s standards, it increases the rate to check it. RBI increases the RR to infuse liquidity with a lower cost of funds for borrowers.
Impact of Rate Change
As mentioned above, RR change, even by a few basis points (BSP) can bring a heavy impact. RR influences credit availability, liquidity, inflation, and the economic activities in the country. When the financial system witnesses the slightest of change, the economy can flourish or suffer. Likewise, the economy must be pushed down at times to stabilize inflation. The impact of hike or reduction in Repo Rate is as below:
Impact on Inflation & Economy
When the RR is high, banks are reluctant to borrow to avoid paying high interest. Banks take precautions not to overspend the cash reserve by minimizing the loan grants. This obstructs the money flow and also the economic activities. However, it also deters inflation.
When RBI reduces the rate, it facilitates the banks to borrow, spend and invest. More money may be used for more investment purposes. Increased cash flow will lead to faster business cycles and an economic boom.
Impact on Bank Loan Rates
When the rate is high, banks have to clear off their loans to RBI with a higher interest amount. They may charge a higher rate of interest (ROI) on loans to customers to compensate for the same. RBI discourages borrowing from banks and banks discourage the customers. This drains out excess liquidity from the market and thereby controls the inflation rate.
As the rate declines, banks may also lower down their rates to seek more customers. Loan applications may be easier for customers of commercial banks as well. It expedites the demand for home loans and others. While the customers find monetary aid at a lower interest, the banks profit through it. The economy blooms due to a rushed money flow as the cost of funds goes down.
Apart from the loans, banks also adjust the interest on fixed deposits (FDs) or savings accounts as per the RR. It is a crucial benchmark according to which banks set up all kinds of rates.
Comparison with Reverse Repo Rate (RRR)
Both are two very prominent policy terms in the Indian economy. RBI decides both these rates according to Monetary Policy. As the name suggests, Reverse Repo Rate/RRR is the reverse of the RR. This means that RRR is the Repurchase Agreement where RBI pledges securities to banks to borrow money. RBI also repurchases them. Both are short-term funds usually for overnight. In a way, the RBI pays the banks to have deposits with it. The impact of change in Reverse Repo Rate is:
- When Reverse Repo Rate is high, banks have a safer option to earn interest than lending to customers. Sometimes, they can earn higher interests than lending. Moreover, they lend to RBI against government-backed securities
- Low RRR demotivates the banks to lend to or have deposits with RBI. They would rather opt to lend loans to customers to accrue higher interests and profits
Repo Rate vs Reverse Repo Rate
- Banks borrow RR loans from RBI while banks lend Reverse Repo Rate loans to RBI
- Both require collateral or pledge of securities and bonds. Banks provide securities to take RR loans. Whereas, RBI provides securities to take Reverse Repo Rate loans or bank deposits
- RRR is also an important mechanism to control inflation just like RR. Both are a part of the LAF- Liquidity Adjustment Facility. It is following ways:
- Both when increased, lower down the money flow slowing down the economy but controlling the inflation as well. When RR is high, banks defer borrowing loans to avoid paying high interests. But when RRR is high, it incentivizes the banks to deposit money in RBI. Both hinder the lending to the customers and hence cash supply is slow
- Similarly, low RR promotes banks to borrow from RBI and lending to customers. On the other hand, low RRR enhances banks to rather do customer lending than to have RBI deposits. Both Repo Rate and Reverse Repo Rate pace up economic activities when their rates are low. This is because the money supply increases with low rate regimes
- Reverse Repo Rate is dependent on Repo Rate. RRR is always lower than RR because the spread between the two is RBI’s income. Also because interests in loans tend to be higher than deposits. But both these rates are usually in line with each other. RBI attempts to change them keeping them aligned. RBI Repo Rate today (as on publishing date) is 4% whereas RRR is 3.35%
Wrapping it up:
Thus, RBI uses Repo Rate as a control mechanism to manage inflation and balance the economy. RBI takes the contrary position in the event of rising or fall of inflationary pressures. RR increase helps in contracting the economy when the price uprise is escalating way beyond. RR also paces up the economy when it is cooling off when the rate goes low. It also speeds up or pulls down the lending frequency and the loan amounts of the banks. Loans rates like that of home loans are often Repo Rate Linked Lending Rate. Hence, it may fluctuate according to the RR change.
- A rate cut will intensify the post-pandemic inflation that exists especially in certain sectors
- A rate hike will impede the money flow in the market which is required to boost the economy after the lockdown