Ever heard of the term inflation? While you can always find a detailed explanation here, inflation is the sustained increase in the price of goods and services, resulting in a fall in the purchasing power of money. Some amount of inflation is good for economic growth, but anything above the targeted level needs to be controlled. Central banks are mandated to keep inflation low, and the repo rate is an instrument that helps them perform the function.
A simple definition is that the repo rate is the interest rate charged by the central bank of a country (Reserve Bank in India) while lending money to commercial banks. To understand the repo rate, you should understand the lender-borrower relationship in its entirety. A good grip on the repo rate would help you make informed lending and investment decisions. Read on as we explain everything in a relatable, easy-to-understand manner, focusing on the Indian banking system.
Understanding repo rate
Repo stands for Repurchasing Agreement/Option. It is a short-term borrowing-lending agreement where one party lends money to another at an interest. The rate of the repurchase agreement is called the repo rate. Simple as it may sound, it needs some explanation to put things in perspective.
Inflation, as we have seen above, is a situation where the demand for products and services is high, which, in turn, drives prices even higher. Practically speaking, consumers take loans from banks at affordable rates—to buy homes, automobiles, and household goods—increasing the money supply in the economy. As banks tend to experience shortage of funds owing to the huge demand, they look to borrow money from the central bank.
Now, the ball is in the central bank’s court, and they are mandated to monitor the money supply in the economy and keep inflation under check. Commercial banks borrow money from the RBI using bonds and other instruments as collateral. The interest rate levied by the RBI is the repo rate. Any attempt by the RBI to hike the rate ensures that borrowing from banks becomes costlier, discouraging consumer spending.
Repo rate calculation
The repo rate isn’t your tongue-twisting financial jargon. Instead, it is fairly easy to understand, provided it is explained with the help of a simple calculation as given below.
We know that it is the rate of interest at which the central bank lends money to commercial banks. For example, if a commercial bank borrows Rs. 1,00,000 from the RBI at the rate of 10%, the interest payable will be Rs. 10,000.
What are the repo rate components?
Now that you have a basic understanding of the repo rate, it would be useful to have some familiarity with the terms associated with it.
Commercial banks often need to borrow money from the RBI to maintain liquidity. Cash is the most liquid of all assets. Banks disbursing loans in large quantities, consumers withdrawing funds aggressively, and banks investing user funds in long-term instruments are situations that can lead to a liquidity crunch—wherein banks approach the RBI for funds.
The central bank makes tweaks to this rate to rein in inflation. The idea is to discourage banks and, eventually, consumers from borrowing funds. And when borrowing takes a hit, monetary supply decreases—lowering the demand for products and services. And this helps curb inflation.
The RBI doesn’t provide loans out of the goodness of its heart. Commercial banks need to offer gold, bonds, treasury bills, and other collateral assets to avail the same.
Cash reserve ratio
Did you know that every rupee you deposit in the bank doesn’t go to the bank’s vault? Banks are mandated to keep a portion of that money with the central bank or the RBI. At present, the ratio is 4.50%. For instance, if a user deposits ₹1,000 in a bank, ₹45 needs to go to the RBI. Also, banks cannot earn interest-specific returns from the cash reserves parked with the RBI.
CRR is yet another tool to combat inflation, which works hand in hand with the repo rate.
Repo rate vs. Bank rate
While the repo rate is the interest charged by the RBI on short-term loans, the bank rate concerns long-term loans. Also, in the case of repo rate, banks need to pledge collateral (securities), which can be repurchased at a predetermined rate to repay loans. Bank rates, on the other hand, are collateral free.
Here is a more detailed differentiation between these two terms:
|Repo rate||Bank rate|
|Short-term RBI to bank lending rate||Long-term RBI to bank lending rate|
|Requires collateral and security repurchasing||No collateral required|
|Also termed the repurchase rate||Also termed rate of discount|
|Meant to increase short-term liquidity||Meant for coping with cash-crunch during bank runs or recession|
|Always lower than the bank rate||Higher of the two|
|Hike affects customers indirectly||Hike impacts customers directly|
What is the repo rate finalized by RBI?
On Friday, 30 September 2022, the RBI hiked the repo rate by 50 basis points or 0.50%. Therefore, the rate at the time of writing holds at 5.90%.
How does the current repo rate affect you and me?
The repo rate hike by the RBI was on the expected lines. However, the mid- to long-term impact of the same can be far-reaching.
Here are some of the ways it could affect you:
- Increase in car, personal, and home loan EMIs as the cost of borrowing will percolate down the customer base.
- Standard deposits and FDs might see better returns as banks try to encourage user-specific deposits to lower dependency on the RBI. Repo rates are always lower than savings account and FD rates.
- Loan pre-payments will likely become popular as users try to reduce the interest component.
What is the reverse repo rate?
While the repo rate concerns RBI to bank lending, the reverse repo rate is essentially the opposite—the interest rate charged by the banks for parking funds with the RBI. Also, the amount of funds parked is calculated separately from the mandatory cash reserve ratio.
When banks have additional funds, they can lend the same to the central bank and earn interest. Therefore, when the reverse repo rate increases, banks are incentivized to park more money with the RBI— reducing the money supply, liquidity, and inflation in the process.
Repo rate vs. reverse repo rate
Now that you know a bit about the reverse repo rate, let us see how it differs from the repo rate:
|Repo Rate||Reverse Repo Rate|
|Rate of interest on RBI to bank fund flow||Rate of interest on bank to RBI fund flow|
|Hike is to discourage banks and users from borrowing more||Hike is meant to reduce liquidity across the economy with banks parking money with the RBI|
|Larger goal of controlling inflation||Larger goal of controlling money supply by ensuring that the excess liquidity moves to the central bank instead of staying with the commercial banks.|
Repo and reverse repo work in tandem
By now, it should be clear that the repo and reverse repo rates have the primary goal of controlling inflation and reducing the money supply in the economy. The increase in repo rate achieves this by making money costlier—banks will need to charge higher interest rates from consumers—thus discouraging lending. On the other hand, the increase in reverse repo rate incentivizes banks to park their excess funds with the RBI, instead of lending to consumers.
In short, a fine balance between both rates is important for the healthy functioning of an economy.