Understanding Repo Rate and Reverse Repo rate

Published: April 6, 2021 at 4:03 pm

Last Updated on April 6, 2021 at 4:03 pm

I am sure that at some point while watching the news on TV or skimming through news articles, you might have come across headlines like these and wondered what they meant: “RBI raises repo rate, reverse repo rate by 25 bps”,  RBI cuts repo rate by 25 basis points” With the RBI’s rate-setting panel (the monetary policy committee) likely to announce interest rates on April 7th (1st quarter FY 21-22), let us discuss in simple words what the repo rate and the reverse repo rate stand for.

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It is well known that the RBI acts as a regulator for all commercial banks in India. Let us now understand two of the most important functions of the RBI :

1)To control the supply of money in the economy: This means how much money is there in the economy and the market’s purchasing power.

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2)To control the cost of credit: This is nothing but interest rates that commercial banks charge for lending funds to consumers.

The RBI monitors these functions regularly because they directly impact inflation and the growth of the economy. The RBI, therefore, uses the Repo rate and Reverse Repo rates as tools to control inflation and facilitate economic growth. We will understand how we go deeper, but first, let us understand what these rates signify.

What is Repo Rate?

When we need money but short of it, we approach banks for loans, and they charge us interest on loans. Similarly, when banks are short of funds, they borrow money from the RBI, and the interest rate they pay is called the Repo Rate. For this borrowing, banks provide collateral in the form of Government Securities that they own.

Repo Rate stands for “Repurchase Option”. This means it is an agreement between the bank and the RBI that the bank will repurchase the Government Securities at a pre-determined price once the loan tenure is over. Generally, these tenures are very small. Most of them are rather overnight (1 day).

For Example, Let us say Repo Rate is at 4%, and the RBI lends Rs 1000 to the bank, then the bank will pay an interest of Rs 40 to RBI.

In case the bank is unable to repay, then the RBI can sell these Government Securities in the open market and recover the amount.

What is Reverse Repo Rate?

Whenever you have surplus cash, you deposit some money with a bank, and you get some interest for that amount. Similarly, when banks have surplus funds, they deposit the extra money with the RBI for which they earn interest at a rate known as the Reverse Repo Rate. For this deposit, the RBI provides collateral in the form of Government Securities.

Reverse Repo Rate stands for “Reverse Repurchase Option”. It is an agreement between the bank and the RBI where the Bank promises to resell the Government Securities after the Repo Period. Reverse Repo periods are also generally overnight. This means that the interest paid by the RBI to the bank would be only for 1 day.

How does RBI use Repo Rate and Reverse Repo Rate to control inflation and boost economic growth? Now that you have theoretically understood what Repo Rate and Reverse Repo Rate means let us quickly understand how these rates help the RBI control and manage inflation and drive economic growth.

When writing this article, the RBI has set Repo Rate at 4% and the Reverse Repo Rate at 3.35%. Now let us assume two scenarios, taking the current Repo Rate as 4% and the Reverse Repo Rate as 3.35%.

Scenario 1: Inflation is high, i.e. cost of goods and services are increasing.

The RBI increases Repo Rate to 4.5% and the Reverse Repo Rate to 3.75% to control inflation. This means that the banks will now have to pay the RBI more interest as compared to earlier. Therefore, the banks will now start charging their customers higher interest rates to recover these costs, due to which consumers like us will now take lesser loans. With lesser loans, the supply of money in the market will diminish, which will naturally mean that consumer spending and demands will decrease as people will now rely only on their savings rather than taking loans to buy. As per simple economics, as demand decreases, the prices will also fall, thereby controlling inflation.

So, to control inflation, RBI increases the Repo Rate and Reverse Repo Rate.

RBI raises repo rate, reverse repo rate by 25 bps” – Raising by 25 bps means raising by 0.25%. The next time you see such headlines, you would know what the RBI is trying to do!

Scenario 2: Inflation is low, and RBI wants to promote economic growth

RBI reduces the Repo Rate to 3.75% and Reverse Repo Rate to 3.15% to aid economic growth. This means that the interest paid by banks to RBI will reduce. Therefore they can afford to lend to their customers at a lower rate. This would further encourage consumers to take loans to purchase goods/services, which would supply more money to the economy, thereby increasing demand and striking a healthy balance between growth and inflation.

Therefore, the RBI keeps adjusting both these rates to ensure inflation is not too high and the economy is also growing. (Little inflation is good for the economy).

RBI cuts repo rate by 25 basis points”- You are thus, more likely to see such headlines when the RBI wants to increase the supply of money in the economy and thereby promote growth.

Why is Reverse Repo Rate always lesser than Repo Rate?

This is fairly easy to understand. Our banks charge higher interest rates while lending to consumers and offer lower interest rates for deposits in savings accounts. This is the way banks earn profit for themselves and maintain liquidity. Similarly, the RBI will also charge banks higher rates for loans than they provide them compared to what they are paying them for deposits. This also ensures a healthy cash flow and increases the market’s purchasing power. 

Quick summary and Conclusion

I am sure that you would have had a fair idea of what these terminologies mean and imply for the economy by now. Let us quickly look at a brief recap.

ParameterRepo RateReverse Repo Rate
Borrower and LenderRBI lends to banksBanks deposit with RBI
Interest RatesGreater than Reverse Repo RateLesser than Repo Rate
Main objectiveBorrowing during fund shortageTo adjust the supply of money in the economy
Type of agreementRepurchase Agreement (Repurchase G-Secs on completion of tenure)Reverse Repurchase Agreement (Resell G-Secs to RBI on completion of tenure)
Higher Rate ImpactLoans to consumers become expensiveLesser money supplied to the economy, which lowers spending and controls inflation.
Lower Rate ImpactLoans to consumers become cheaperMore money is supplied to the economy that increases spending and aids growth.

Thus, the RBI has a regular check on the country’s economic condition and may choose to adjust the Repo Rate and Reverse Repo rate from time to time to maintain steady economic growth.

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