What is repo rate, current repo rate, and history of RBI repo rates in India

The repo rate, or repurchase rate, is a crucial financial tool employed by the Reserve Bank of India (RBI) to manage the country’s monetary policy. It is the rate at which commercial banks in India borrow funds from the RBI in case of a shortfall of funds. By altering the repo rate, the RBI can influence the overall money supply, inflation, and interest rates within the economy. This article explores the definition, meaning, and significance of the repo rate, emphasising it’s role and impact on the Indian economy.

Definition of Repo Rate

The repo rate is the rate of interest at which the Reserve Bank of India provides short-term loans to commercial banks, using government securities as collateral. This transaction is part of a repurchase agreement where the commercial bank sells securities to the RBI with the commitment to repurchase them at a later date. The difference between the sale price and the repurchase price determines the repo rate.

Mechanism of Repo Rate

When commercial banks face a liquidity crunch, they can borrow money from the RBI by pledging government securities. The cost of borrowing, determined by the repo rate, is crucial in maintaining liquidity within the banking system.

For example, if a commercial bank sells government securities worth ₹100 crore to the RBI and agrees to repurchase them for ₹104 crore after one year, the effective repo rate is 4%. By adjusting this rate, the RBI can influence the money supply and liquidity in the economy.

Current Repo Rate in India

As of April 2021, the RBI’s repo rate stands at 4%, and the reverse repo rate is 3.35%. These rates have remained unchanged for the last five monetary policy reviews to accommodate the current economic conditions. In May 2020, the repo rate was reduced by 40 basis points from 4.4% to 4%, and the reverse repo rate was set at 3.35%. The RBI periodically revises these rates based on the prevailing economic situation.

Importance of Repo Rate

The repo rate is a powerful tool for the RBI to regulate the economy. It’s importance can be observed in various aspects:

1. Inflation Control

The main goal of the RBI is to ensure price stability. Inflation occurs when there is an excess supply of money chasing limited goods and services, leading to higher prices. By increasing the repo rate, the RBI makes borrowing more expensive for commercial banks, which in turn raises interest rates for consumers and businesses. This reduces borrowing and spending, thereby cooling down inflation.

Conversely, during periods of low inflation or deflation, the RBI might lower the repo rate to encourage borrowing and spending, thus stimulating economic activity.

2. Economic Growth

Economic growth requires a delicate balance of money supply. If the money supply is too tight, it can stifle growth, whereas an overly loose money supply can lead to inflation. By adjusting the repo rate, the RBI can influence the availability of credit. A lower repo rate makes borrowing cheaper for businesses and consumers, which can spur investment and consumption, leading to economic growth. On the other hand, a higher repo rate can help cool down an overheated economy.

3. Banking System Liquidity

Banks often face short-term liquidity mismatches, where they need funds to meet their immediate obligations. The repo rate provides a mechanism for banks to obtain these funds from the RBI, ensuring stability in the banking system. By altering the repo rate, the RBI can influence the liquidity conditions in the market, ensuring that banks have sufficient funds to operate smoothly.

4. Interest Rate Signalling

The repo rate serves as a benchmark for other interest rates in the economy. When the RBI adjusts the repo rate, it sends a signal to the market about the direction of monetary policy. An increase in the repo rate typically leads to higher interest rates for loans and deposits, while a decrease in the repo rate usually results in lower interest rates. This signalling effect helps align market expectations with the RBI’s policy objectives.

Reverse Repo Rate

The reverse repo rate is the interest rate at which commercial banks deposit their excess funds with the RBI. This rate is used by the RBI to absorb liquidity from the banking system. The current reverse repo rate, as of April 2021, stands at 3.35%. By adjusting the reverse repo rate, the RBI can control the amount of funds that banks park with it, influencing overall liquidity in the economy.

SLR and CRR

Apart from the repo rate, the RBI uses other monetary tools like the Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) to manage liquidity and ensure stability in the banking system.

a) Statutory Liquidity Ratio (SLR)

SLR is the minimum percentage of a bank's net demand and time liabilities that must be maintained in the form of liquid assets such as cash, gold, or government securities. The RBI decides the SLR limit, which cannot be used by the bank for lending. By adjusting the SLR, the RBI can influence the lending capacity of banks.

b) Cash Reserve Ratio (CRR)

CRR represents the portion of a bank's total deposits that must be kept with the RBI as liquid cash. The CRR does not earn any interest and cannot be used for lending. By increasing the CRR, the RBI can reduce the funds available for banks to lend, thus controlling inflation.

c) Marginal Standing Facility (MSF)

The Marginal Standing Facility (MSF) is a provision introduced by the RBI to help scheduled commercial banks avail funds overnight. The MSF rate is typically 100 basis points higher than the repo rate. This facility ensures that banks have access to emergency funds, helping maintain stability in the banking system.

The repo rate is a cornerstone of monetary policy in India, providing the RBI with a mechanism to control money supply, manage inflation, and influence economic growth. By understanding the repo rate and it’s implications, policymakers, financial institutions, and market participants can better navigate the complexities of the economy. As economic conditions evolve, the repo rate will continue to be a critical tool in the RBI’s arsenal, guiding the economy towards stable and sustainable growth.