What is Repo Rate and Reverse Repo?

The repo rate is the interest rate at which commercial banks receive short-term loans from the Reserve Bank of India to fulfil the loan demands of their customers (individuals and businesses). The full form of repo rate is a repurchasing option or agreement.

• Only the RBI can impose the repo rate, and this rate is only applicable to commercial banks that require funds on short notice to maintain proper liquidity in their operations. Commercial banks need to exchange securities in return for short-term loans from RBI.

How Does Repo Rate Work?

• Similar to how interest rates work for individuals and businesses when they take a loan from any bank, the repo rate is the interest rate that is levied on commercial banks when they demand a loan from the RBI.

• After the one-day loan period is over, the commercial bank must repay the RBI the total loan amount plus the remainder amount based on the repo rate.

• Let us look at the example below to understand better:

• Bank A borrows ₹1,00,00,000 from RBI due to a sudden liquidity problem.

• Let us assume that the present repo rate in the market is 6%.

• The RBI gives this amount to Bank A with this repo rate for one day.

• After one day is over, Bank A repays the RBI a total amount of ₹1,06,00,000 (principal amount of ₹1,00,00,000 + 6% of this principal amount which comes to be ₹6,00,000).

Inflation - The repo rate is a crucial factor in controlling inflation and its impact. If the repo rate increases, it increases the cost of living and borrowing for laymen, resulting in reduced consumer spending and demand for goods and services.

However, if the repo rate decreases, the opposite happens, which might lead to inflation due to high demand and high prices of goods and services.

Fluctuating Loan Interest Rates - The interest rate for loans available to common people also changes based on the repo rate released by the RBI.

For instance, if the repo rate increases, banks can increase the interest rates for loans for borrowers, making them more expensive and increasing the financial pressure of loan repayments.

Growth of the Economy- The government and RBI use the repo rate to some extent to stimulate economic growth. When the repo rate decreases, it increases the ability of businesses and/or individuals to borrow money and invest more.

This results in increased economic activity. However, in case the repo rate increases, the opposite happens.

As per the recent announcement by RBI, the current repo rate is fixed at 6.50% as of 26th March 2024. This is as per the last announcement of the repo rate on 8th February 2024. Based on a list of economic factors, the repo rate is revised after specific assessments to increase economic growth.

The reverse repo rate is the interest rate at which commercial banks deposit short-term funds with the RBI.
The objective of the RBI behind imposing the reverse repo rate is to allow commercial banks to park their excess money reserves with the RBI and earn interest on their deposited money.

For instance, if multiple banks have a surplus of money due to seasonal demand or any other economic activity, they can deposit their surplus with the RBI at the current reverse repo rate for up to one day.

Controls Inflation - One of the most significant impacts of the reverse repo rate is its ability to control excess liquidity in the economy, reducing the risk of inflation. When banks are offered a high reverse repo rate, they tend to park their surplus funds with the RBI, decreasing the money available for lending and spending.

Increases Value of Rupee - If the reverse repo rate is high compared to other countries, foreign nationals' ability to withdraw their invested or deposited funds in India decreases. This increases the number of investments and deposits from foreign countries in India, increasing the value of the rupee. However, a low reverse repo rate can have the opposite effect.

Interest Rates on Loans - When the reverse repo rate increases, banks tend to increase interest rates on deposits. This is particularly beneficial for individuals looking to invest their money for higher returns. However, the opposite happens if the reverse repo rate decreases.

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