Repo Rate & Reverse Repo Rate – Meaning, Difference, Impact etc.

What is Repo Rate?

Repo rate is the interest rate at which commercial banks borrow money from the Reserve Bank of India during shortfall of funds. it is yet another tool of the central bank to control inflation. During inflation, the repo rate is increased by RBI to discourage commercial banks from borrowing money. As a result, the money supply reduces in the economy and thus helps in controlling inflation.

Similarly, RBI reduces the repo rate in the time of recession. The term Repo stands for repurchase agreement. It is short term, interest-bearing and backed with collateral borrowings. This rate of interest is called the repo rate. It is the rate at which banks sell their bonds and securities to RBI along with signing a contract of repurchasing it at a pre-decided price in a future date.

Reverse Repo Rate

Reverse Repo Rate is the opposite of the repo rate. It is the interest rate at which the Reserve Bank of India borrows money from all other commercial banks for a short span of time when they have excess cash reserves. This is a tool used by the central bank when it feels there is excess money floating with the commercial banks. An increase in reverse repo rate is beneficial for the banks as they will get a higher percentage of interest. So commercial banks always prefer to lend their money to RBI instead of any other customer as it is less risky.

Repo rate transaction

Objectives of Repo rate and reverse repo rate

• Repo rate and reverse repo rate are tools used by RBI to deal with the deficit and excess of funds and liquidity in the market
• These are the reference rates for the banks to determine their lending and borrowing rates
• These are considered as the most effective tools used to gain price stability and economic development

Role of Repo rate and Reverse repo rate

Regulates cash flow- These policies are framed by the Reserve Bank of India to offer or borrow loans from the banking sector when there is a deficit or excess of funds in the economy. The primary reason is to avoid any crisis of liquid assets in the economic system. So repo policy increases supply of money money to the banking system, and Reverse Repo absorbs money from the banking system.

Stability in prices- Repo rate and reverse repo rate helps the central bank to curb inflation and assists in economic development. They maintain a balance between both inflation and economic growth.

Difference between repo rate and reverse repo rate

Impact of Repo rate

On banking System

• Increase in repo rate -Rise and fall of repo rates affect the lending and rates of deposits of the banks. Banks may determine their liquidity position and cost of funds before raising their rates of deposits and rates of credit. This high-interest rate on banks is passed on to the customers in the form of higher lending rates. Especially home loans and other loans with floating rates are most affected. This higher lending rates may result in a decrease in ending business and hence in the profitability of the bank. After the analysis of their position banks may also increase the rates of interest, they offer on deposits to attract more deposits and inflow of cash.
• Reduction in Repo rate Reduction in the repo rate is beneficial for the banks as they can borrow money from RBI at a cheaper rate. This results in a reduction in interest rates on loans to end customers. This reduction in loan rates as a result of the decreased base lending rate will attract more customers. Increased lending will increase the profitability of the banking system.

On end customers

• Increased Repo rate - When Repo rate is increased; it becomes difficult for commercial banks to borrow funds from RBI. Due to fewer funds, banks may increase their lending rate. This, in turn, discourages a common man from borrowing loans. Hence, the purchasing power of consumers decreases. This may further result in higher deposit rates as an exercise to attract more customers and increase the inflow of money by the banks.
• Reduction in Repo Rate Reduction in Repo Rate by the central bank will encourage banks to borrow short term loans from the central bank. Increased funds will let banks to lend money to the common man at a much lower interest rate. This will raise the purchasing power of the common man and can quickly achieve their financial goals.

On the Economy

• Increased repo rate An increase in the repo rate makes it more difficult for the banks to avail loans from the central bank. As a result, banks may increase their lending rates which in turn make it more difficult for common man to borrow money from banks. This decreases the money supply in the market and reduces consumption, expansion, and production. As a result, increased repo rate hinders economic development.
• Reduced repo rate - With the reduction of repo rates, the short term loans for banks becomes relatively cheaper. This may also reduce the lending rates of the banks. Consumption increases with a decrease in lending rates as people are left with more money. And increased consumption has a positive effect on GDP growth. Easier availability of loans at cheaper rates encourages businesses to grow and expand. As a result, there is an overall development in the economy.

Impact of Reverse Repo Rate

On Banking System

• Increased Reverse Repo Rate When there is excess money floating in the banking system, RBI increases the Reverse Repo Rate so that banks can gain more interest on lending the money to RBI.
• Reduction in Reverse Repo Rate When there is a reduction in reverse repo rate, banks will not be profitable as they will not earn higher returns on this investment.

On end customers

• Increased Reverse Repo Rate Increased reverse repo rate helps customers by reducing the inflation rate. This happens when banks lend more money to RBI leaving fewer funds in the financial market. This reduction in the money supply helps in curbing the inflation rate.
• Reduced Reverse Repo Rate With reduced reverse repo rate the banks will not invest their money in lending the central bank. This results in a higher supply of money into the market. Hence, more money for fewer goods will lead to a rise in inflation, which is a significant concern for the common man.

On National Economy

• The enhancement in the reverse repo rate is done with the primary objective to suck out excess money floating in the banking system to regulate the inflation rate. Recently, it has increased the reverse repo rate by 25 basis points and increased the earlier rate of 5.75 to 6%. With this increase in reverse repo rate, the money supply to the market will decrease, and hence the inflation rate will decrease.

Current RBI rates in the Indian banking system