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The Reserve Bank of India (RBI) extends credit to Indian commercial banks or other financial institutions in exchange for government assets. This is known as the repo rate. In 2023, the current repo rate was 6.50%. The money supply in the market increases when the RBI reduces the Repo Rate, which might support economic expansion. On the other hand, a high rate may impede economic expansion. This article defines what is repo rate is, describes its operation, and discusses how it currently impacts India’s economy.
Defining Repo Rate
You might be wondering what is repo rate. It is the interest rate at which a nation’s central bank provides credit to private banks. The Reserve Bank of India (RBI), the nation’s central bank, employs the repo rate to control the economy’s liquidity. Repo rates in banking are associated with “repurchase agreements” or “repurchase options.” In times of financial scarcity, commercial banks obtain loans from the central bank, which they repay based on the relevant repo rate.
The central bank offers these short-term loans in exchange for assets like government bonds or treasury bills. The central bank uses this RBI monetary policy repo rate to raise bank liquidity or manage inflation. When it becomes necessary to regulate prices and limit borrowing, the government increases the repo rate. Conversely, the repo rate is lowered when additional money is needed to encourage economic expansion and replenish the market.
A change in the repo rate would eventually impact public borrowings such as house loans, EMIs, etc. since a rise implies commercial banks must pay more interest on the borrowed money. Numerous financial and investment instruments indirectly rely on the repo rate, from the interest rates imposed by commercial banks on loans to the returns from deposits.
How Does Repo Rate Work?
As mentioned, the Indian central bank uses the RBI repo rate to limit the money that may move in the market. The RBI increases the repo rate when inflation affects the market.
Banks that borrow money from the central bank at this time will have to pay higher interest rates due to a rise in the repo rate. This prevents bank rate vs repo rate from taking on new debt, which lowers the quantity of money in circulation and counteracts inflation. The RBI lowers its repo rates during recessions as well.
How does The RBI use the Repo Rate For Economic Stability?
Banks borrowing from the Reserve Bank of India must pay the cost of credit to the top bank and the interest the borrower must pay on the original amount borrowed from a financial institution. The repo rate is the interest rate at which the Reserve Bank of India loans money to commercial banks and other financial institutions in India. A repo deal is one in which the RBI loans money to financial institutions in exchange for collateral.
The repo rate is a crucial tool that the central bank uses to manage inflation and guarantee that the economy has enough liquidity. Thus, the RBI periodically decides the repo rate based on the nation’s economy.
The RBI Governor leads the Monetary Policy Council, which decides the current repo rate. The RBI modifies the repo rate to bring about economic stability. Changes in the repo rate affect commercial banks’ cost of credit and, consequently, lending rates. As a result, changes in the repo rate often affect other rates, such as those on bank deposits and house loans.
Increase in Repo Rate
- According to the RBI, conditions may worsen when the economy has a high inflation rate.
- In situations where there is a chance of currency depreciation.
- When it wants to lessen any speculative activity that occurs in the foreign currency market.
- The potential for asset bubbles to develop as a result of excessive capital creation.
Decrease in Repo Rate
- The circumstance whereby the RBI considers that demand-driven price increases are improbable and that both inflation and the budget deficit are adequately under control.
- When the economy begins to slow down, the RBI wants to encourage a more accommodative RBI monetary policy repo rate to speed up the economy.
- If the RBI determines that the balance of payments situation is normal.
How Do Repo Rate Changes Control Inflation And Growth?
Less money is available for lending to banks when the RBI repo rate is high, and vice versa. Since credit is the foundation of a capital-led economy, reducing credit availability brought on by high borrowing costs may reduce the amount of money in circulation, discouraging economic activity. This is mainly employed when controlling price increases in the economy is necessary, and inflation is excessive relative to the RBI’s goal criteria. The main price for this is restrained economic development.
Conversely, the RBI may lower the repo rate as well as the reverse repo rate when inflation is under control, and economic growth is slowing down. This reduces borrowing costs and expands the pool of available loans. More money is left in the hands of companies and the public at large, which promotes economic expansion.
What is the Reverse Repo Rate?
The reverse repo rate is the interest rate at which a central bank borrows money from commercial banks to sell assets that it plans to buy back. It functions as the repo rate’s complement and is essential to executing the RBI monetary policy repo rate. Commercial banks are more likely to park their surplus money with the central bank when the reverse repo rate is greater, affecting the financial system’s liquidity conditions. According to www.rbi.org.in, the current reverse repo rate as of November 30, 2023, was 3.35%.
Difference between Repo Rate and Reverse Repo Rate
| Feature | Repo Rate | Reverse Repo Rate |
| Definition | Government securities secure the central bank’s interest rate on loans to commercial banks. | The interest rate at which the central bank borrows funds from commercial banks by providing them with government assets. |
| Nature | It is an interest rate set by the central bank. | It is the interest rate earned by commercial banks. |
| Purpose | The central bank uses this to regulate inflation, the money supply, and market liquidity. | The central bank uses this to absorb excess liquidity in the banking sector. |
| Borrower | The central bank provides loans to commercial banks. | Commercial banks lend to the central bank. |
| Security | Collateral for commercial banks is government securities. | Government securities are provided as collateral by the central bank. |
| Duration | Typically brief (lasting overnight). | Usually brief (often lasting only one night). |
Conclusion
A country may effectively achieve its macroeconomic goals of balancing growth and inflation by adjusting its monetary policy rates. Although rates can be rationalised rapidly, their effects take time to manifest. Since the RBI monetary policy repo rate is simply one of many instruments at the decision-maker’s disposal, its efficacy is best served by simultaneously implementing all other related measures (fiscal policy, for instance).
FAQs
The repo rate is set by the Monetary Policy Committee (MPC), chaired by the governor of the Reserve Bank of India (RBI).
The Repo Rate is decided every two months by the Monetary Policy Committee of the Reserve Bank of India.
The Liquidity Adjustment Facility (LAF) is a monetary policy tool that allows banks to borrow funds through repurchase agreements. The RBI repo rate and Reverse Repo Rate are examples of the LAF.
Basis Points (BSP) serve as a unit of measurement, representing one-hundredth of a percentage point or equivalent to one ten-thousandth of a percent.
The Marginal Standing Facility (MSF) is the rate at which scheduled banks can borrow overnight funds against securities from the Reserve Bank of India, which is higher than the Repo Rate.
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