What is Repo Rate?

Introduction

Repo rate is the interest rate at which a nation's central bank (in India, the Reserve Bank of India) loans money to commercial banks in the event of a funding shortage. Monetary authorities use the repo rate to manage inflation.

The Monetary Policy Committee (MPC) declared that the repo rate had increased by 0.25 percent to 6.50 percent on February 8, 2023. The MPC made the decision to maintain the reverse repo rate at 3.35 percent during its meeting.

This article explains what is the meaning of the repo rate.

What is Repo Rate?

A repurchase deal or option is referred to as a "repo." The RBI uses a monetary tool to help commercial banks during the financial crunch. The loans are issued against collateral such as treasury bills or government bonds. By the repo rate definition, the interest rate applied to these loans is known as the repo rate. Later, commercial banks can buy back the collateral after paying off the debt. 

The RBI finalises the interest rate through policies. The rates are set as per the current economic condition of the country. The governor of RBI chairs the monetary policy council to finalise the repo rate. 

It is a key tool for the RBI in regulating inflation trends and maintaining market liquidity. The repo rate and inflation are inversely related, as when the repo rate increases, inflation declines, and vice versa. It also affects the interest rates of home loans, personal loans, and bank deposit rates. 
 

Repo Rate Function

The repo rate influences retail lending rates and inflation. Therefore, to combat inflation, the government entrusts the central bank with taking the necessary steps. As a result, the central bank restricts the money supply during inflation. This eventually leads to rising lending rates in the market. 

Individuals then begin to restrict extra spending and the money supply drops to decrease inflation. Therefore, reducing the repo rate stimulates expenditure, demand, and consumption of commodities, resulting in economic expansion. 
 

Components of Repo Rate

Repo rate controls the country's inflation, liquidity, and money supply. Furthermore, it has a direct impact on the banks' borrowing patterns. Legitimately, the Reserve Bank of India has some standards to follow before approving any loan to a central bank. The repo rate is a crucial factor in maintaining financial peace in the country. Its components include the following:

●    Inflation

The repo rate maintains a lid on inflation. The Reserve Bank of India increases or decreases the repo rate based on the country's economic condition. Altogether, it regulates the economy. 

●    Hedging and leveraging

Reserve Bank of India focuses mainly on hedging and leveraging. The central bank buys security bonds from commercial banks and financial institutions. 

●    Short-Term Borrowing

RBI offers short-term loans up to an overnight tenure, after which the commercial bank buys back the collateral by paying the loan amount.

●    Collateral and Security Elements

The Reserve Bank of India accepts gold and bonds as collateral in exchange for a loan.

●    Cash Reserve or Liquidity 

Various banks borrow money from RBI to hold liquidity or cash reserves as a precaution.
 

Comparison Between Repo Rate and Reverse Repo Rate

Repo Rate    

●  The repo rate has a higher interest rate than the reverse repo rate.
●  The main force limiting inflation is the repo rate.    
●  The primary goal is to fill the funding shortage.
●  It is responsible for purchasing the contract again.
●  Currently, the repo rate is 6.50%.

Reverse Repo Rate

●  The reverse repo rate has a lower interest rate than the repo rate.
●  The money supply is under the control of the reverse repo rate.
●  The reverse repo rate provides the economy with liquidity.
●  The reverse repurchase agreement is used to charge it.
●   Reverse repo rates are currently 3.35%.
 

Impact of Repo Rate

An increase in the repo rate directly impacts borrowers. The repo rate is a controlling arm that regulates economic capacity and has the following effects:

●  Fights Inflation

During high inflation, the RBI takes measures to control the flow of money. For example, the RBI governor and council members increase the repo rate to ensure control of cash circulation. As a result, it affects the economy's growth negatively and helps control inflation.

●  Boosts liquidity in the market

When the RBI has to inject funds into the system, it reduces the repo rate. As a result, loans and investments take an economic turn. Furthermore, the entire money supply in the economy experiences growth.
 

Calculation of Repo Rate

RBI in India holds the position of the central bank of the country. It takes all decisions to regulate the economy. The repo rate is part of the economic structure of the country. Thus, RBI decides the percentage depending on the scenario. 

Here is an example explaining how the repo rate works.
XYZ, a nationalized bank, needs Rs. 10,000 in funds. They approach the RBI and borrow funds against bonds and securities as collateral. XYZ bank has to provide Rs. 10,000 worth of bonds as security to RBI to receive Rs. 10,000 in cash.

RBI will charge a 5% interest rate on the bond/security. This 5% repo rate will amount to Rs. 500. Therefore, while repaying the cash, XYZ will get the bond back and pay Rs. 500 as the interest.