RBI Monetary Policy- Repo Rate and Reverse Repo Rate
Whenever the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) announces its policy review, the most talked about term of this review meeting is- Repo Rate, whether it is increased or decreased. Repo rate has its own impact on commercial banks, on general public and on economy as a whole. They are important for functioning of money supply in the system and hence it becomes important to understand repo rate and reverse repo rate. So let’s understand it in detail-
Repo Rate: It is the interest rate at which commercial banks can borrow funds from the RBI. Whenever commercial banks borrow money from RBI, they need to provide collateral in form of Government bonds and treasury bills. Hence, Repo Rate is simply the lending rate charged by RBI on commercial banks.
It is important to note that this transaction is not a simple loan transaction, it takes place as per an agreement called repurchasing option. The word “repo” is acronym of this agreement i.e. REPurchasing Option. According to this agreement, RBI gives funds to banks and against that banks provide securities to RBI. So, in this transaction RBI is purchasing the securities and bank is selling the securities. Now bank has to re-purchase the same securities from RBI by giving them the same funds plus interest on it. Usually this transaction happens overnight, so banks have to pay 1 day interest and the principal amount. It can go upto 7 days if it is written in agreement. If bank does not repay to RBI at aforesaid time, RBI can sell the securities in open market.
Reverse Repo Rate: The reverse repo rate is opposite of repo rate. It is the rate at which RBI borrows funds from the commercial banks. When banks have surplus money, they use to deposit it with RBI and RBI pay interest on that deposit. This transaction also happens overnight, so RBI has to pay 1 day interest and the principal amount. It also happens through agreement and RBI also provides the Government securities to banks. RBI uses these funds to create liquidity in the economy and manage money supply in the system.
RBI, Banks and General public relation: For your financial needs you need a bank; same way banks also need RBI as a financial entity to cater their financial needs. For banks, RBI lends and borrows funds with interest rates of repo rate and reverse repo rate respectively. The repo rate will always be higher than the reverse repo rate. The difference between the two rates is the RBI’s monetary income. Just like in your case bank’s loan rates are always higher than its deposit rates. The difference in these two is the bank’s income. The current repo rate is 6.25% and reverse repo rate is 3.35% as on December 2022.
Repo rate and reverse repo rate in an example:
Let’s say SBI, a commercial bank, needs funds of Rs. 10 crore so it goes to RBI. Now, RBI provides funds to SBI for one day at the interest rate of 6.25% which is current repo rate. In turn SBI will provide any Government bond or Treasury bill (usually more than the value of Rs. 10 crore) to RBI. This transaction happens overnight so next day SBI will give Rs. 10 crore plus 1 day interest i.e. around Rs. 17000. If SBI does not give this amount to RBI, RBI can sell the security in open market. These transactions are very common between RBI and banks, even if it happens only for one day but transactions numbers are very high that’s why small change in repo rate impacts in big way.
How Repo Rate and Reverse Repo Rate can control inflation or push economic growth–
RBI to control Inflation: To control inflation RBI keeps repo rate HIGH; if the repo rate is high it means RBI charging high interest to banks. Now banks need to pay more interest to RBI and hence banks need money. They can get it only from its customers, hence it also need to increase interest rates of loans. If loan interest rates are high, people don’t prefer to take loans and just rely on their savings for the growth of their business or their personal needs. The money supply in the system will be less which will reduces demand of goods and services and in turn the prices will go down and inflation will be in control. In 2008, during US subprime crises inflation was going out of control at that time RBI makes repo rate all time high i.e. 9%.
RBI to push growth: In order to push growth, RBI keeps repo rate LOW; if the repo rate is low it means RBI charging less interest to banks. Now banks pass this benefit to its customers and reduce interest rates on loans. If loan interest rates are low, more people will come forward to grab the opportunity and take loans for the growth of their business or their personal needs. The money supply in the system will increase which will increase the demand of goods and services and it will increase the growth and also the prices will go up. Hence with growth, inflation will also increase. Inflation in controlled way supports the overall growth.
Final Note: This is how RBI makes balance between Inflation and Growth. Both aspects are very important for economy to grow as a whole and RBI is balancing it very well for decades.