Podcast | Digging Deeper: What are repo rates and reverse repo rates and how do they affect you and me?

this is the third time in succession that the Reserve Bank has cut the repo rate in 2019.

The Reserve Bank has yesterday brought down the repo rate by 0.25 percentage points, or 25 basis points. After the cut, the repo rate now is at 5.75%. This is the lowest that the repo rate has been at, and it touches this figure again after nearly nine years; the last time the repo rate was at 5.75% was in July 2010, where it remained for three months. Since then, the repo rate has been at 6% or higher.

Incidentally, this is the third time in succession that the Reserve Bank has cut the repo rate in 2019, after the earlier reductions in February and April.

The repo rate and the reverse repo rates affect a lot of micro and macroeconomic activities and have consequences right down the chain. They are an important part of the monetary policy of the country and are monitored and regulated with the aim of achieving specific macroeconomic objectives including money supply, which percolate down from institutions to individuals and hence affect the common man too at a personal level.

Let’s take a look at what repo and reverse repo mean. First, what is generally referred to as the repo rate?

The Repo Rate is short for repurchase option rate. The Reserve Bank is, of course, the nation’s banker, and oversees and regulates the supply of money. Not just that, it also ensures the health and stability of the banking system through the statutory liquidity ratio, which is the part of the money that the various banks have to deposit with it so that the money never runs dry.

When the supply of money in the system comes down, the banks will need more money to lend. In such a scenario, the commercial banks borrow from the RBI. The RBI charges a rate of interest for these loans, and that is what we come to know as the repo rate.

These loans that the banks take from the RBI are short-term borrowings to tide over the shortage of money supply for their own lending. These short-term loans are backed by collateral, generally bonds and securities, which the banks then repurchase while repaying the loan. The loans are often for a day or so, and when the banks take a repo, they pledge securities as collateral. After the term, in this case, a day – has elapsed, the banks repay the loan along with the charged interest rate, and also redeem the pledged securities. In this sense, these reports are very much like a loan that an individual would take from a bank, with a promise to repay within a period.

The Reverse Repo – well, the term makes the meaning self-evident. Whereas the repo is the loan where the commercial banks borrow from the RBI, in the case of the Reverse Repo, the opposite happens – the RBI borrows from the commercial banks. In effect, it is the commercial banks depositing their excess funds with the RBI and getting interested in it.

It is just like what happens with an individual and a bank. When you or I am in need of money, we approach the bank and take a loan at a particular rate of interest, with mutually agreed upon terms. When we have money to spare, we take our cash and deposit it with the bank – in a savings bank, a fixed deposit, or a recurring deposit account. Of course, the interest that the bank charges us is higher than the interest it pays us on any of our deposits. It is through the positive differential in the deposit and lending rates that the bank earns its profit.

The situation is similar in the case of the Repo and Reverse Repo too. The RBI is higher up the pecking order, and it has a positive differential where the deposit and lending rates vis a vis the commercial banks are concerned. Generally, it’s in the RBI’s favor to the tune of 0.25 percentage points. Currently, the repo rate, after its latest reduction, is at 5.75%, and the reverse repo rate is at 5.50%.

The reverse repo allows the banks to earn some interest on their surplus funds, which would otherwise lie idle because the banks are unable to lend or deploy the money in investments.

That is perhaps where the similarities end. While between an individual and the bank, it is a one-to-one transaction or agreement, and the effect of the interest rate stops at that, the repo and its interest rate have an effect right through the system.

The repo is one of the important ways by which the banks borrow. This is in addition to their borrowing from their customers by means of their deposits. This borrowing through the repo route has been increasing steadily. As a result, any increase or decrease in the repo rate affects the interest rate of retail loans and also deposits.

So, how do the repo rate and the reverse repo rates influence or affect the economic climate of the country?

On a macro scale, the repo and reverse repo rates affect the liquidity in the system. The rates are used to control inflation and money supply. Let’s take a look at the repo. The Reserve Bank uses the repo as a tool of the Indian monetary policy. It varies the interest rate on the repos to keep a check on liquidity, inflation and money supply.

Consider inflation. When inflation rises, it indicates a higher supply of money in the system. The surplus money reduces its value, and this happens through things becoming more expensive. The RBI constantly monitors this. When it feels that inflation levels are high enough to have a negative impact, it increases the repo rate. Of course, this is only one way to deal with inflation. The hike in the repo rate is a means to reduce the money supply in the economy.

When the repo rate increases, the interest rates across the board are also affected and show a corresponding increase as the banks pass on the cost of their funds to their customers. This makes borrowing expensive, and fewer loans are taken. This eventually reduces the money in circulation, thus making it a scarcer commodity, thereby increasing its value, and reducing inflation.

At the same time, higher interest rates on deposits also attract funds from individuals and agencies, who park more funds in bank deposits and hence spend less. This also acts to reduce the money supply in the economy.

The opposite happens when there is a lack of liquidity in the system, or the economy needs a cash infusion. The RBI reduces the repo and the effect is the reverse of what we talked about just now. People borrow more and spend more because saving gives relatively lesser returns. Money supply increases and consequently economic activity to increases.

The reverse repo, as an instrument, has similar ends in mind. When inflation is high, for instance, the reverse repo rate is increased. As a result, the commercial banks end up putting more of their money in with the RBI because the returns are higher. This reduces the amount of money available for them to lend, thus automatically reducing the money supply.

When the reverse repo rate is high, the banks are assured of a better return on funds they park with the RBI, and hence they have a good reason to put more of their money there. This also gives them an assured better profit on a risk-free investment. When the reverse repo is reduced, though, the banks have to depend on their regular lendings through their normal routes, where, naturally, though the returns are higher, so are the risks. This also increases the money supply in the economy, and when there is more money in the economy there is inflation. So, a reduction in the reverse repo, even if you forget the economy, affects you personally by increasing inflation and making things costlier.

Of course, it is not as simple as all that. The economy is a complex beast, and everything does not flow one way. When the RBI increases or lowers the repo rate, some sectors in the economy will gain, while others will lose out for the time being. Also, the repo rate is not necessarily linked to the base lending rate of the banks. So, a reduction in the repo rate need not reflect in a reduction in the interest rate of loans given out by the banks.

For the individual, the progress of the repo rate is also an indication of the way the economy is functioning and also a pointer to the way the government wants the economy to move. An increase in the rate means that bank deposits – in the form of savings accounts or fixed deposits – will earn higher returns. When the rate is lowered, you get lesser returns from your deposits. At the same time, it is an opportunity to take loans, buy things and build non-monetary assets because the cost of money is lower.

The rate cut earlier this week has come on the back of a period of low inflation and low growth in the economy. In the recent repo rate cut, one of the observations made was that in the previous two rate cuts in February and April, the repo rate came down cumulatively by 0.50 percentage points, this was not passed on to the consumer; at his end, the reduction was less than half of it. The expectation this time, as was articulated by RBI governor, Shaktikanta Das, was that the rate cut would reflect in rates to consumers too. This was an attempt by the government to put more money into the system and re-energize an economy that has remained sluggish for quite some time now. The hope is that this cut in the rate will revitalize various sectors in the economy, paving the way for higher growth in the rest of the financial year and farther ahead.

As the RBI’s Monetary Policy Committee, which unanimously decided on the rate cut, stated: “The headline inflation trajectory remains below the target mandated to the MPC even after taking into account the expected transmission of the past two policy rate cuts…. So, this transmission will naturally find its impact on consumer loans, consumer durables loans, two-wheeler loans, etc. There are good chances of interest rates on new loans in these segments coming down.”

That puts the effect of the latest repo rate cut perfectly into perspective as far as the common man is concerned. Inflation is not likely to reach uncomfortable or unhealthy levels, but you are still going to have cheaper money to use!

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