What Is Repo Rate And Reverse Repo Rate?
When taking a loan from a bank or investing, the most important term is the interest rate.
The interest rate is highly dependent on the Repo Rate and understanding this relationship is crucial for investors. Fluctuations in the repo rate can influence the interest on your loan and fixed-income investments like fixed deposits or corporate bonds.
In this blog, we will understand what the repo rate means, how it works, and how it affects an investor.
Introduction To Repo Rate
Like you and me, Banks also need to borrow money in many cases, such as liquidity shortages, reserve requirements, or emergencies. In such cases, commercial banks go to RBI for their requirements.
Commercial banks pledge their securities to get a loan from the RBI. Under this agreement, the RBI lends money to commercial banks at an agreed-upon rate. This rate of interest charged by the RBI is called the Repo Rate.
How Does Repo Rate Impact The Economy?
Think of the repo rate as the ‘interest rate for banks’ decided by the RBI. When the RBI adjusts this rate, it is like turning a knob that they can either encourage or discourage commercial banks from borrowing money from the RBI. Let us understand how this impacts the larger economy and your investments.
The repo rate is a critical tool the RBI uses to manage money circulation in the market. During 2020-2022, when COVID-19 hit, RBI lowered the repo rate to 4%, which remained the same for almost two years1. This lower repo rate was an attempt to encourage banks to borrow more. This, in turn, would enable them to lend more at lower rates to individuals and businesses, thus increasing the total liquidity available in the economy.
Conversely, during periods of high inflation, the RBI raises the repo rate, discouraging commercial banks from borrowing money from the RBI. This decreases the amount of money circulating in the market because banks have less capital to lend to businesses and consumers. This leads to less demand for goods and services, resulting in regulation of rising prices.
Historical Repo Rates From 2014 To 2024
As can be seen in the chart above, repo rates in India have been steadily decreasing from 2014 to 20202. The RBI reduced them sharply when the COVID-19 pandemic hit. Since 2022, however, the RBI has sharply increased the repo rate to mitigate rising inflation.
The current repo rate in India is fixed at 6.50% by the RBI on 8th February 2024.
How Are Your Loans And Investments Impacted By A Change In The Repo Rate?
Here are some more areas directly affected by the repo rate-
- Changes in repo rates lead to adjustments in home loans, personal loans, and car loan EMIs. An increase in repo rates increases the cost of these loans
- FDs are expected to gain value as investments. Changes in repo rates affect the bank’s ability to lend and deposit.
- Repo rates and the stock market are directly tied. When RBI raises the repo rate, businesses scale back their expansion, leading to a slowdown of the economy.
Calculation Of Repo Rate By The Reserve Bank Of India
The RBI calculates the repo rate in agreement with other banks based on market conditions such as inflation levels, economic growth, unemployment rates, and financial market stability.
What Is The Reverse Repo Rate?
A reverse repo rate is the opposite of a repo rate. It is an interest rate at which the RBI borrows money from other commercial banks.
Difference Between Repo Rate And Reverse Repo Rate
Parameter | Repo Rate | Reverse Repo Rate |
Lender and Borrower | The borrower is the commercial bank, while the lender is the RBI | The commercial bank is the lender, while the RBI is the borrower |
Aim | The repo rate aims to manage short-term fund shortages | The reverse repo rate aims to decrease the overall circulation of money in the economy |
Operation Mechanism | Commercial banks use government bonds in repo rates as collateral to obtain the RBI funds | In reverse repo rate transactions, surplus funds are deposited by the commercial banks in the RBI to earn interest on the deposit |
Impact on Cost of Funds and Money Supply | A higher repo rate results in a higher cost of funds for commercial banks, making loans like personal loans, car loans, etc., more expensive | As opposed to the repo rate, with higher reverse repo rates, the money supply in the market decreases as the banks deposit the surplus funds in the RBI |
Conclusion
The Reserve Bank of India decides the repo rate and plays a crucial role in the country's money circulation. Fluctuations in the repo rate can lead to various effects. Understanding the impact of these fluctuations helps you make more informed investment decisions.
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Frequently Asked Questions On What Is Repo Rate
1. What happens if the repo rate increases?
When repo rates increase, borrowing becomes expensive for commercial banks, leading to reduced lending and lower money supply.
2. What key factors influence the repo rate and reverse repo rate decisions?
The repo rate and reverse repo rate are influenced by economic factors such as inflation levels, economic growth, global economic situations, and the financial stability of the market.
3. How does the reverse repo rate impact liquidity in the banking system?
The reverse repo rates impact the market's liquidity by influencing the amount of funds that commercial banks deposit in the RBI. Commercial banks deposit more money in the RBI if the reverse repo rate is higher.
References:
- Reserve Bank of India <https://tinyurl.com/2srwdpn3>
- CEIC Data <https://tinyurl.com/t2cvjwnf>
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