Impact of Repo Rate and Reverse Repo Rate

Current Repo Rate is 6.25 percent (According to 12th December 2022), after increasing 35 basis points (bps). The repo rate is sometimes referred to as Repurchasing agreement rate or repurchasing order rate; which is the rate of interest that commercial banks need to pay to the Reserve Bank of India on the borrowed amount. While borrowing a significant amount from the RBI, commercial banks need to sell their securities to the RBI to ensure fund security in case of a shortfall of funds and maintain liquidity. The Repo rate plays an important role in the economic growth of the nation and has a huge impact on inflation as well thus RBI uses it as its main tool to control inflation.

While on the other hand, the reverse repo rate is contrary to the Repo rate, and commercial banks receive handsome interest on their deposited funds from the RBI. Thus the rate of interest paid by the RBI to the commercial banks for their funds is referred to as the reverse repo rate. For example if a bank borrows a sum of Rs 500 crores from RBI at a rate of 4% then after 1 year, the bank will need to repay Rs. 520 crores.

Repo Rate: Key Points

The repo rate simply works as the common rates of interest work on bank loans. But unlike simple loans when a commercial bank needs a loan overnight they seek RBI and the rate of interest charged by the RBI on that loan is called the repo rate. Not every bank can get a loan from RBI as the RBI verifies the securities and bonds held by a bank and keeps them as a guarantee until the bank repay the whole amount with the repo rate. The Repo rate is equally important for both RBI and commercial banks as the repo rate increases government wealth while on the other hand providing cash to the banks to maintain liquidity.

Necessary Parameters to Execute a Repo Transaction:

There are certain necessary parameters for a repo transaction and some of them are mentioned below.

1. The Reserve Bank of India is independent to regulate the repo rate depending on the rate of inflation in the country.
2. The RBI lends money to the commercial banks for a short period on the behalf of securities deposited by the banks. Also, RBI holds the right to sell those bonds if a bank fails to repay the amount within a specified time.
3. The securities and bonds are also accepted in gold bonds by the RBI.

The Effect of the Repo Rate on the Economy:

The repo rate has a huge impact on a nation’s economy as it is essential to regulate the cash flow in the market. The Indian monetary policy controls and regulates the repo rate depending upon the market’s liquidity and inflation cash flow. Additionally, the repo rate directly affects the borrowing capacity of banks as the repo rate is higher borrowing capacity of banks gets reduced. Repo rates play a major role in controlling inflation in the country for example if there is high inflation RBI increases the repo rate thus reducing the cash flow in the market. As the cash flow slows down production capacity and investment slows down thus pulling the inflation rate down. While on the other hand, RBI only decreases the repo rate when there is a fall in the inflation rate thus, this situation encourages banks to borrow money from RBI.

However, there are negative impacts on the repo rate as well, for example during a rise in inflation RBI increases the repo rate thus resulting in decreased cash flow leading to a fall in the production capacity of industries, and thus resulting in a price hike in necessary goods and services and also leading to unemployment. While on the other hand, RBI tries to lower the repo rates to pump more funds and thus increase the liquidity in the market. The repo rates of RBI and the interest rates on loans of commercial banks are proportional to each other If the repo rates get reduced interest rates on loans to get reduced and vice versa. As soon as the repo rates fall investors borrow a huge sum of money from the banks and invest it in multiple sectors thus leveraging the economy of the country.

Impact of Reverse Repo Rate on Inflation:

When there is excess liquidity in the market then the reverse repo rate comes into play to absorb the liquidity from the market. Unlike the repo rate in the reverse repo rate, the RBI encourages commercial banks to invest their funds in RBI and receive a decent interest on the principal amount. As a result, the banks remain left with lesser funds thus restricting more investments and leading to a fall in the inflation rate. The commercial banks quickly get convinced to deposit their fund under RBI as RBI is the central bank of India and banks receives a decent interest from the RBI.

Difference Between Repo Rate and Reverse Repo Rate:

Repo Rate	Reverse Repo Rate
Rate of interest paid by banks to the RBI	Rate of interest paid by RBI to the banks
The current repo rate is 6.25%	The current reverse repo rate is  3.35%
It is used to increase the liquidity	It is used to absorb the liquidity
It is always higher than the reverse repo rate	It is always lower than the repo rate

Current Repo Rate and its Impact on the Indian Economy:

The repo rate is not stable and keeps varying with the inflation rate, also modifications in these repo rates have a different impact on every sector. Some sectors observe a significant profit while some may bear huge losses. For two consecutive financial years, RBI has been cutting down the repo rates. As per the RBI, in the financial year 2022-23, this is the consecutive 5th hike and the repo rate for the current quarter of the financial year 2022-23 is 6.25%, however, the reverse repo rate is 3.35% respectively.  This Repo Rate is now touched its highest level since August 2018. A decrease in the repo rate attracts huge investments and thus helps the Indian economy to grow at a rapid pace. The repo rates are varied to keep inflation in control and therefore it has a significant impact on the economy.

The Repo rate plays a crucial role in the Indian economy as the repo rate directly affects the interest rates of banks and thus when the repo rate is less the Indian economy starts growing at a rapid pace. As all the major investors start investing in new businesses as they also have to pay less interest to the bank, thus resulting in the economic growth of India. In the last financial year i.e 2021 the repo rates have significantly decreased by the RBI. Thus during this period, the economic growth of India pumped up at a significant rate.