When you avail a loan from a bank, you pay interest on the loan amount. Similarly, banks also pay interest when they borrow money from the central bank or the Reserve Bank of India (RBI). The rate at which commercial banks borrow from the RBI is known as the repo rate.
Looked at in another way, the repo rate refers to the rate at which the RBI lends money to commercial banks in exchange for government securities. Commercial banks borrow from the RBI to meet their liquidity requirements or for other statutory measures.
The repo rate is one of the most important tools used by the RBI to manage the supply of money in the economy and, in turn, control inflation. While managing the supply of money and controlling inflation may sound complicated, this blog aims to simplify these concepts for you.
Repo rate in the Indian context
The repo rate, short for repurchase rate, often appears in macroeconomic and banking conversations. It refers to the interest the commercial banks pay to RBI for overnight loans secured by government securities.
RBI uses the repurchase rate to control the money supply in the economy. It is a benchmark interest rate used by the Reserve Bank of India (RBI) to facilitate the smooth operation of the monetary system.
Now, we will understand repo rate hikes and the role of the Monetary Policy Committee in deciding repo rates.
Historical repo rate hikes
Historically speaking, India maintained a stable 4% repo rate from May 2020 to April 2022. In May 2022, the RBI hiked the repo rate by 40 basis points to 4.40% to control inflation. One basis point is one-hundredth of a percentage point.
The May 2022 repo rate hike was followed by 5 more hikes, taking the repo rate to the current level, which is 6.5%. The last repo rate hike was in February 2023.
Changes in the repo rate have their impact beyond the give-and-take relationship between the RBI and commercial banks. The change in rates also influences other rates and reserve ratios.
Monetary Policy Committee (MPC) overview
Initially, all important interest rate decisions were taken by the RBI governor. The RBI Act 1934 was amended in 2016 to constitute a six-member committee known as the Monetary Policy Committee (MPC) to decide interest rates.
The first MPC was constituted on September 29, 2016. The present MPC members, as notified by the Central Government in the Official Gazette of October 5, 2020, are as under:
- Governor of the Reserve Bank of India—Chairperson, ex officio;
- Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy—Member, ex officio;
- One officer of the Reserve Bank of India to be nominated by the Central Board—Member, ex officio;
- Prof. Ashima Goyal, Professor, Indira Gandhi Institute of Development Research —Member;
- Prof. Jayanth R. Varma, Professor, Indian Institute of Management, Ahmedabad—Member;
- Dr. Shashanka Bhide, Senior Advisor, National Council of Applied Economic Research, Delhi—Member.
(Members referred to at 4 to 6 above, will hold office for four years or until further orders, whichever is earlier)
The core functions and duties of the MPC are:
- The MPC determines the policy repo rate required to achieve the inflation target.
- The MPC is required to meet at least four times a year. The quorum for the meeting of the MPC is four members.
- Each member of the MPC has one vote, and if the number of votes remains equal, the Governor can exercise his casting vote.
- Each Member of the Monetary Policy Committee has to give in writing the reasons for voting in favor of, or against a proposed resolution.
Repo rate mechanics
The repo rate is a money market instrument used to manage the flow of money in the economy. Here is the definition and explanation of the repo rate and its role in regulating liquidity in the economy.
Definition and function of repo rate
According to the RBI, repo is a money market instrument, which enables collateralized short-term borrowing and lending through sale/purchase operations in debt instruments.
Under a repo transaction, a holder of securities sells them to an investor with an agreement to repurchase at a predetermined date and rate. In the case of repo, the forward clean price of the bonds is set in advance at a level that is different from the spot clean price by adjusting the difference between repo interest and coupon earned on the security.
Here, the entity selling the security will be a financial institute such as a bank and the entity buying the government securities will be the central bank, i.e., the RBI.
The repo rate is used by the RBI in its fight against inflation as it is used to maintain a stable economic environment in the economy.
Role of repo rate in controlling inflation and growth
India’s inflation rate peaked at 7.41% in September 2022. The RBI has pegged its inflation upper tolerance limit at 6%. Therefore, when the inflation rate started rising in late 2021 through early 2023, RBI employed all the tools in its armory to tame inflation.
RBI’s most powerful weapon in its fight against inflation is the repo rate. The current repo rate is 6.50%. RBI has maintained this repo rate since February 2023, when it hiked the repo rate by 25 basis points taking it to the current levels. RBI has been able to bring inflation down by increasing the repo rate.
How RBI uses the repo rate to control inflation
- Money Supply Management
The repo rate is the rate at which banks borrow from the RBI to meet their short-term liquidity needs. Therefore, when the RBI wants to curb inflation, it will hike the repo rate, increasing the borrowing cost of banks.
The increasing cost of borrowing will force banks to reduce their borrowing and lending activity, decreasing the supply of money in the economy. This will lead to a fall in consumer spending and investments, which will help cool inflation.
- Credit Availability
Banks will pass on increased borrowing costs to their customers. Businesses and individuals will find it less favorable to borrow at increased costs. Therefore, a higher repo rate discourages borrowing, curbing demand.
- Demand-Side Management
RBI influences the demand for goods and services by increasing the repo rate. With an increase in the repo rate, borrowing becomes expensive, leading to reduced consumer spending and investment. This helps prevent excessive demand-driven inflationary pressures in the economy.
- Managing Inflation Expectations
The repo rate decisions are watched closely by consumers, businesses, and financial markets. A repo rate hike from the RBI is a signal for market participants to expect lower inflation in the future. For example, businesses may moderate their price hikes and consumers would delay their purchases.
Impact of repo rate changes
Repo rate changes impact the country’s financial system and the economy.
Effect on economy and monetary policy transmission
The repo rate is decided by the Monetary Policy Committee (MPC). The MPC in its bi-monthly policy review announces its decision on the key lending rates and ratios in the economy. In this meeting, they also announce their policy stance.
For instance, the MPC stance of the December 2023 policy review was ‘withdrawal of accommodation’. This meant that the RBI would remain focused on curbing the money supply in the economy to control inflationary pressures.
The MPC usually adopts one of the following stances:
- Accommodative
An accommodative stance means the central bank is prepared to expand money supply to boost economic growth. Here, the RBI is willing to cut interest rates to boost demand.
- Neutral
A ‘neutral stance’ suggests that the central bank can either cut the rate or increase the rate. This stance is typically adopted when the monetary policy is equally focused on inflation control and growth.
- Hawkish
A hawkish stance indicates that the central bank’s top priority is to keep inflation low. The central bank will hike interest rates to curb the money supply and thus reduce the demand.
- Calibrated tightening
Calibrated tightening means during the current rate cycle, a cut in the repo rate is off the table. However, the rate hike will happen gradually.
The link between inflation and economic growth
A repo rate hike is used to control inflation in the economy. This is because a higher repo rate means a higher cost of borrowing for the banks. Banks will pass the higher cost of borrowing to their customers, leading to an increased cost of borrowing for people.
The increased cost of borrowing will reduce the supply of money in the economy, leading to a decrease in demand and eventually a reduction in inflation. To boost growth, the RBI cuts the repo rate to reduce the cost of borrowing and boost liquidity in the economy.
But this doesn’t mean the repo rate is always used to reduce inflation. Repo can also be used to boost demand in the economy by maintaining a steady rate of inflation in the economy. Inflation, as you will read in our blog post, isn’t always bad. On the contrary, a steady rate of inflation is necessary for economic growth.
Repo rate in comparison to other rates
The RBI uses a bunch of tools other than the repo rate in its fight against inflation or to boost growth. Some of these tools are:
Reverse repo rate
The reverse repo rate is the mirror image of the repo rate. The reverse repo rate is the rate at which the RBI borrows money from commercial banks within the country. It is a monetary policy instrument that can be used to control the money supply in the country.
Standing Deposit Facility (SDF) and Marginal Standing Facility Rate (MSF)
A Standing Deposit Facility is an overnight deposit facility that allows banks to park excess liquidity (money) and earn interest. Through a standing deposit facility (SDF), the RBI sucks out excess liquidity in the banking system as part of the Liquidity Adjustment Facility (LAF) corridor.
A marginal standing facility (MSF) is a window for banks to borrow from the Reserve Bank of India in an emergency when inter-bank liquidity dries up completely. Through the marginal standing facility (MSF), RBI supplies liquidity when conditions are challenging.
The MSF rate is pegged 100 basis points or a percentage point above the repo rate. Under MSF, banks can borrow funds up to one percentage of their net demand and time liabilities (NDTL).
Bank Rate
The bank rate is the rate charged by the central bank for lending funds to commercial banks. Bank rates influence the lending rates of commercial banks. A higher bank rate will translate to higher lending rates by the banks. To curb liquidity, the central bank can raise the bank rate and vice versa.
Cash Reserve Ratio and Statutory Liquidity Ratio (SLR)
Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the RBI. CRR is set by the RBI depending on inflation in the country. The RBI increases the CRR to curb inflation and vice versa.
Statutory Liquidity Ratio or SLR is the minimum percentage of deposits that a commercial bank has to maintain in the form of liquid cash, gold, or other securities. It is the reserve requirement that banks are expected to keep before offering credit to customers. These are not reserved with the Reserve Bank of India (RBI) but with banks themselves. The SLR is fixed by the RBI.
CRR (Cash Reserve Ratio) and SLR have been the traditional tools of the central bank’s monetary policy to control credit growth, flow of liquidity, and inflation in the economy.
Repo rate beyond India
The repo rate is an important tool for managing inflation. The repo rate management came to the forefront of economic policy across the world in 2020 as global inflation started to spiral out of control.
Repo rate in the United States
According to the Federal Reserve, the repo rate in the US remained unchanged at 5.36 as of Wednesday, January 24. Repo rate in the US averaged 2.31 from 1995 until 2024, reaching an all-time high of 6.94 in September of 2019 and a record low of -0.01 in December of 2009.
Current scenario and future projections
Current repo rate in India
The current repo rate in India is 6.5%.
Future trends and projections
The RBI’s monetary policy review in December stated that the MPC’s monetary policy stance will be ‘withdrawal of accommodation’ for the time being as the MPC is focused on controlling inflation. This means that the MPC is unlikely to cut rates or lower the repo rate until the inflation rate comes down to the RBI’s inflation target of 4%.
Conclusion
The repo rate plays a crucial role in maintaining economic stability. The central bank increases the repo rate if it wants to bring down rising consumer prices. A rate hike will increase the cost of borrowing, which in turn, will discourage individuals and businesses from availing credit.
FAQs
What is repo rate?
Repo rate is the rate at which the Reserve Bank of India (RBI) lends money to commercial banks or financial institutions in India against government securities.
What is the current repo rate?
The current repo rate in 2023 stands at 6.50%. Changes in repo rate affect the flow of money in the market.
What is the difference between bank rate and repo rate?
The repo rate is the rate at which RBI lends to commercial banks by buying securities. The bank rate is the lending rate at which commercial banks borrow from RBI without securities.
How is repo rate availed by banks, practically speaking?
Repo rate is the rate of interest at which commercial banks in India borrow money from the Reserve Bank of India. Commercial banks are required to deposit securities such as government bonds or treasury bills as collateral to avail these loans from the central bank of the country.
Define SLR and CRR
Cash Reserve Ratio (CRR) is the percentage of money that a bank has to keep with the RBI in the form of cash. Statutory Liquidity Ratio or SLR is the minimum percentage of deposits that a commercial bank has to maintain in the form of liquid cash, gold, or other securities.
