The Reserve Bank of India develops and implements monetary policies with the express intent of regulating the amount of money available in the economy in order to promote different facets of economic growth. Such monetary policies’ main goals are to encourage economic growth by stabilizing prices, controlling the amount of bank lending, enhancing the effectiveness of the financial system, encouraging investment, and broadening the range of financial markets. In this sense, the repo rate and reverse repo rate are monetary policy tools used by the RBI to assist manage the amount of money in the economy. IPB one of the best banking training institute will let you know more about what is repo and reverse repo rate.
What is Repo Rate vs Reverse Repo Rate?
Repo Rate: “Repo” is an acronym for “repurchase agreement.” Repo is a short-term, collateral-backed borrowing mechanism, and repo rate refers to the interest rate charged for such borrowings. Repo rate is the rate at which the Reserve Bank of India lends money to Indian commercial banks when such banks are short on cash. Commercial banks sell RBI government securities and bonds with the understanding that they will later purchase those same securities and bonds from the latter at a predetermined price that will include interest. The current repo rate is 5.15% as of February 2020.
Reverse Repo Rate: Reverse repo as the name suggests is an opposite contract to the Repo Rate. Reverse Repo rate is the rate at which the Reserve Bank of India borrows funds from the commercial banks in the country. In other words, it is the rate at which commercial banks in India park their excess money with Reserve Bank of India usually for a short-term. Current Reverse Repo Rate as of February 2020 is 4.90%.
Importance of this
- The Reserve Bank of India uses repo and reverse repo as monetary tools to address the market’s lack of money and liquidity. It is an essential tool the central bank uses to control the flow of money.
- Repo and reverse repo rates have an effect on bank lending rates.
- The Reserve Bank of India uses repo and reverse repo as their most effective and efficient methods for achieving price stability and fostering economic growth.
- Banks may simply and safely manage their liquidity needs with the use of repo and reverse repo agreements.
Relevance of the Repo Rate and the Reverse Repo Rate
Regulation of Liquidity: Numerous facilities are made available to commercial banks under the liquidity framework the RBI created in order to satisfy their need for quick liquidity or a lack of cash. The primary goal of the liquidity framework is to use repo agreements to prevent any liquidity crises in the Indian banking system. Similar to this, the RBI has a system in place for managing excess cash and money in the banking system, ensuring that there isn’t an excessive amount of liquidity present. And the name of this framework is reverse repo. Repo operations essentially inject money into the Indian banking system. Reverse repo, on the other hand, uses the Indian banking system’s liquidity to finance itself.
Effects of RBI’s Increase in Repo Rate Reverse Repo Rate
The RBI’s rise in the repo rate and reverse repo rate has the following effects:
Repo Rate Increase: A rise in the repo rate makes it more expensive for commercial banks to borrow money from the RBI, which may result in an increase in the interest rates that apply to loans. Fewer loans are applied for and disbursed as interest rates rise, which limits the amount of money available in the market and could have a negative impact on the growth of the nation’s economy.
Increase in Reverse Repo Rate: The RBI may opt to raise the reverse repo rate if the banking system has too much liquidity. Banks can earn more interest on their excess cash deposited with the Reserve Bank of India when the reverse repo rate is increased. As more of the bank’s surplus funds are deposited with RBI instead of being lent out, the general flow of money into the markets will be reduced because this is a safer investment choice for banks.
Impact of RBI’s reductions in rate
The following are the effects of RBI’s reductions in the repo rate and reverse repo rate:
Impact of Repo Rate Cut: Any change in monetary policies first has an impact on the banking industry. A decrease in the repo rate may make it more affordable for banks to borrow money from the Reserve Bank of India, increasing the amount of liquidity in the banking system. This may cause banks to lower their lending rates for customers, resulting in longer-term loans at lower costs. Consumers can borrow and spend more as bank loans become more affordable, which increases consumption and may eventually spur economic growth. However, whether the bank decides to pass on the benefits of the RBI repo rate reduction to its consumers through more affordable loan offers will determine how this plays out.
Impact of Reverse Repo Rate Cut: When the Reserve Bank of India decides to lower the reverse repo rate, banks earn less on their excess funds deposited with the RBI. The amount of liquidity available in the economy as a whole rises as a result of the banks’ increased investment in lucrative routes like money markets. The availability of other potentially less hazardous and similarly lucrative investment possibilities, as well as the bank’s internal liquidity condition, will all play a role in the decision, which may or may not result in reduced interest rates on loans for the bank’s clients.
