Repo Rate: Repo Rate is the rate at which the Reserve Bank of India (RBI) lends money against government securities to commercial banks and financial institutions in India. The current Repo Rate for 2023 is 6.50 percent. Changes in the Repo Rate influence the market’s money flow. When the RBI reduces interest rates, it stimulates economic growth by increasing the money supply. It hinders economic growth when interest rates are excessive. This article discusses in depth the Repo Rate definition, its operation, and the current impact of the RBI Repo Rate (RR) on the economy.
What does the term Repo Rate mean?
Repo Rate full form or the term ‘REPO’ stands for ‘Repurchasing Option’ Rate. It is also known as the ‘Repurchasing Agreement’. In times of financial hardship, individuals obtain loans from banks and pay interest on these loans. Likewise, commercial banks and financial institutions confront a lack of capital. Additionally, they can borrow money from the country’s central bank. Any nation’s Central Bank lends money to commercial banks at a rate of interest on the principal amount.
This return on investment is the Repo Rate if a bank accepts a loan against any type of collateral. The RBI purchases eligible securities such as Treasury bills, gold, and bond documents from commercial banks. When the loan is repaid, the RBI will allow institutions to repurchase the securities. Consequently, it is referred to as the ‘Repurchasing Option.’ If they obtain a loan without collateral, the interest rate is the Bank Rate.
Similarities and differences between the Repo Rate and the Bank Rate
The RBI can monitor economic activity and money transfer in the market with both instruments. The distinction between the two is the exchange of government securities for a loan from the RBI. Listed below are some commonalities and key distinctions between the two:
Similarities
Both have an effect on liquidity and maintain inflation control. Customers must receive the benefits of reduced interest rates from banks and financial institutions. Consequently, they must lower the Base Rate. The base rate is the lowest rate at which banks are permitted to lend to customers. The Reserve Bank of India determines the base interest rate for all banks. When the Base Lending Rate decreases, loans become more affordable due to the decrease in EMIs.
Dissimilarities
These are the distinctions between the two:
- Commercial banks and financial institutions borrow funds without collateral at the Bank Rate. Repo Rate uses securities as collateral for loans.
- Bank Rate is typically higher than RR because the RBI provides unsecured loans through the former.
- Bank Rate loans are typically granted for a longer period of time, whereas Repo Rate loans are designated for a shorter duration.
- Changes in either rate may be passed on to commercial bank customers, but the Bank Rate has a direct impact on the loan rate. To adjust loan interest rates in response to variations in the repo rate, banks may require some time. This is due to the brief duration of the offer. The repo rate typically affects large loans like mortgages.
Significance of the RBI Repo Rate
This is one of RBI’s Monetary Policies. The RBI Governor presides over the twice-monthly Monetary Policy Committee (MPC) meetings. It typically consists of six individuals. Together, they determine, administrate, and alter the policy rates.
The RBI modifies it based on the country’s liquidity deficit or surplus. The following components comprise RR transactions between banks and the RBI:
- RBI lends money to banks under a legal agreement that necessitates collateral. It can include stocks and bonds. RBI hedges and leverages bank securities to provide financial assistance.
- RR loans and transactions are considered to be short-term borrowings. Banks receive overnight or term funds while the Reserve Bank of India holds the securities.
- Banks are able to repurchase securities at a predetermined date and price. This price is the loan quantity, and interest is calculated using the RR method.
- RBI has the authority to sell these securities if banks default and fail to return the funds by a specified date.
- Banks borrow funds to make up for insufficient currency reserves. As a legal requirement, they sometimes borrow funds to maintain the minimum reserve balance.
How RR Operates?
The banks obtain loans from the RBI by pledging securities, which they repurchase the following day. The loan is an overnight funding source for banks experiencing a liquidity shortage. Although the loan at RR is typically for one day, banks may require it for longer. One-day loans are classified as Overnight Repo, while longer-term loans are termed Term Repo. Variable Rate Term Repo is another name for Term Repo. RBI typically announces auctions for Term Repo, which can range in duration from 7 to 28 days. When inflation exceeds RBI’s standards, the rate is increased to combat it. RBI raises the RR in order to enhance liquidity and reduce the cost of funds for borrowers.
Impact of Rate Variation
As mentioned previously, even a small alteration in the RR can have a significant impact. RR influences the country’s credit availability, liquidity, inflation, and economic activity. When the financial system undergoes even the smallest shift, the economy can either flourish or suffer. Similarly, the economy must sometimes be depressed to stabilise inflation. The effects of a Repo Rate increase or decrease are as follows:
Effects on Inflation and the Economy
When the RR is high, banks are reluctant to lend in order to avoid paying excessive interest rates. By minimising loan grants, banks take precautions to avoid exceeding the cash reserve. This hinders the passage of money and economic activities. In addition, it discourages inflation.
When the RBI reduces the rate, banks are able to borrow, spend, and invest more freely. More funds are available for investment purposes. Increased cash flow will result in accelerated business cycles and economic expansion.
Influence on bank lending rates
When the rate is high, banks must repay their loans to the Reserve Bank of India (RBI) with a higher interest rate. To mitigate this, they may charge a higher rate of interest (ROI) on loans to customers. RBI discourages bank borrowing, while banks discourage customers. This drains the market of excess liquidity and thereby regulates the inflation rate.
As the rate falls, banks may reduce their rates to attract more customers. Additionally, loan applications may be simplified for customers of commercial institutions. It accelerates the demand for mortgages and other loans. While the customers receive financial aid at a reduced interest rate, the bank’s profit. The economy flourishes as a result of a rapid money flow as the cost of funds declines.
In addition to loans, banks also modify the interest rates on fixed deposits (FDs) and savings accounts in accordance with the RR. It is a crucial benchmark against which banks establish all types of interest rates.
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Comparative analysis to Reverse Repo Rate (RRR)
Both are highly prominent economic policy terms in India. The RBI determines both of these rates based on its Monetary Policy. As suggested by its designation, the Reverse Repo Rate/RRR is the opposite of the RR. Thus, RRR is the Repurchase Agreement in which RBI pledges securities to banks in order to borrow money. RBI repurchases them as well. Both are short-term, typically overnight, funds. In a sense, the RBI compensates banks for holding deposits with it. The effect of a shift in the Reverse Repo Rate is:
When Reverse Repo Rate is high, banks have a more secure means of earning interest than by lending to customers. Occasionally, they can generate greater returns than lending. In addition, they lend against government-backed securities to RBI.
Low RRR discourages banks from lending to or holding deposits with RBI. They would rather lend money to consumers to increase their profits and interest rates.
Repo Rate vs Reverse Repo Rate
Banks obtain RR loans from RBI, while banks provide RBI with Reverse Repo Rate loans.
Both require a security or surety pledge as collateral. Banks provide collateral for RR loans. In contrast, RBI offers securities for Reverse Repo Rate loans and bank deposits.
RRR, like RR, is an essential mechanism for controlling inflation. Each is a component of the LAF- Liquidity Adjustment Facility. In the following manners:
Both, when increased, reduce money flow, thereby reducing the economy and controlling inflation. When RR is high, banks postpone loan borrowing to avoid paying high-interest rates. However, a large RRR encourages banks to deposit funds with the RBI. Both impede lending to consumers, resulting in a sluggish cash supply.
Low RR encourages banks to borrow from the RBI and lend to clients. In contrast, low RRR encourages banks to lend to customers rather than hold RBI deposits. When both Repo Rate and Reverse Repo Rate are low, economic activity is accelerated. This is because the money supply expands under low-interest-rate regimes.
Reverse Repo Rate is dependent on Repo Rate. RRR is always less than RR, as the difference between the two is RBI’s source of revenue. Additionally, loan rates are typically higher than deposit rates. In contrast, these ratios are typically comparable. RBI attempts to alter them while maintaining their alignment. RBI Repo Rate is 6.50% as of the date of publication, while RRR is 3.45%.
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