What is the meaning of Repo Rate

India's central bank, i.e. Reserve Bank of India (RBI), keeps a close check on the economic conditions prevailing in the country and then decides the repo rate. But what is the repo rate? It is the rate at which RBI extends credit to commercial banks against their treasury bills. The six-member monetary policy committee decides the repo rate, which meets twice a month to deliberate on whether to increase, decrease or maintain the repo rate.

Repo rate directly affects the rate of interest at which you borrow loans from your bank. Let's learn in detail about the repo rate and how it affects the cost of borrowing for ordinary citizens.

What is the meaning of Repo Rate?
 

Just as a borrower has to pay interest against the loan from their bank, banks also need to pay interest against their borrowings. All commercial banks can borrow loans from the RBI by selling eligible securities such as treasury bills. Banks usually take loans whenever they face a cash crunch and require liquidity for conducting their day-to-day banking activities.

The rate at which banks have to pay interest to RBI is known as the Repo Rate. Repo is the short form of Repurchase Option or Repurchase Agreement.

Banks agree to repurchase these securities in the future at a predetermined price.

Current and past Repo Rates

The repo rate has fluctuated over the years, depending on the economic conditions in India. The RBI typically increases the repo rate when it wants to control inflation, and decreases it when it wants to stimulate economic growth.

When was the RBI repo rate changed?
 

The Reserve Bank of India's (RBI) Monetary Policy Committee (MPC) last revised the key repo rate on February 8, 2023, increasing it by 25 basis points from 6.25% to 6.50%. This marked the fourth consecutive repo rate hike by the MPC since the tightening cycle commenced in May 2022.

The repo rate is the interest rate at which the RBI lends to commercial banks and it influences the overall interest rates in the economy. The RBI has been raising rates steadily to contain inflation which has remained above the 6% upper limit of the target range for several months.

The MPC meets every six weeks to review domestic and global economic conditions and determine if any rate action is warranted. However, the RBI can also revise rates in between scheduled meetings in response to unexpected developments.

What is the difference between the repo rate and the MCLR rate?
 

The key difference is that the repo rate is set by the RBI while the MCLR (Marginal Cost of Funds based Lending Rate) is determined by commercial banks. The repo rate is the interest at which RBI lends to banks and acts as a benchmark for overall interest rates. In contrast, the MCLR is the minimum rate at which banks can lend and is based on four components – marginal cost of funds, operating expenses, tenor premium, and margin. Banks reset their MCLR periodically based on the repo rate and cost of funds. Thus, the repo rate influences the MCLR but they are not the same.

What is the relationship between inflation and repo rate?
 

The repo rate, which is determined by a country's central bank, has a very close relationship with inflation in the economy.

When inflation is high or rising, central banks will typically raise the repo rate. Raising the repo rate increases the cost of borrowing for both consumers and businesses. This reduced spending power translates into lower demand in the economy, which helps cool inflation. Simply put, higher repo rates slow down economic activity and control prices.

Conversely, when inflation is under control and within targeted limits, central banks can reduce the repo rate. Lower repo rates make it cheaper to borrow money, which leads to higher spending by consumers and businesses. This boosts overall economic growth and activity.

Therefore, inflationary trends directly influence the central bank's stance on the repo rate. Managing inflation is a key mandate for central banks and adjusting the repo rate is a monetary policy lever they actively use to maintain price stability in the economy. The repo rate and inflation essentially share an inverse relationship.

Repo rate vs reverse repo rate
 

The repo rate is the rate at which RBI lends money to commercial banks for the short-term. It involves banks selling securities to the RBI and agreeing to repurchase them later at a higher price. This way RBI infuses liquidity into the banking system.

The reverse repo rate, on the other hand, is the rate at which banks park their surplus funds with the RBI for short periods. Here, banks buy securities from RBI and sell them back later. Through the reverse repo, RBI absorbs excess liquidity from the system. The reverse repo rate is always kept lower than the repo rate to encourage banks to borrow from RBI rather than parking funds. It essentially regulates liquidity conditions.

Significance of the Repo Rate
 

The repo rate is one of the most important tools in the RBI's Monetary and Credit Policy. It acts as a liquidity management mechanism whereby RBI tightens or eases the repo rate to keep the economy afloat.

Whenever the economy is going through inflation, RBI raises the repo rate to discourage businesses and the general public from taking loans. This slows down the investment-related activities in the country and helps combat inflationary movements that may have led to a sudden soar in prices of everyday goods and services.

On the other hand, during times of recession, RBI reduces the repo rate, which further leads banks to decrease the interest rate on loans to the general public. This, in turn, gives a boost to the overall economy and gives a push to spending activities as people want to borrow loans at lower rates of interest.

Central banks worldwide devise various strategies to keep a tight check on their economies. RBI repo rate is used extensively as a critical monetary tool to control inflation and tame recession, thus managing the overall flow of money circulating in the market.

How does Repo Rate affect Interest Rates on Loans?
 

The RBI repo rate and the rate of interest at which banks advance loans are directly proportional. Thus with a repo rate hike, the general interest rate charged on loans by your bank will also increase and vice versa.

What effect does repo rate has on the life of a common man?
 

The repo rate directly affects interest rates on loans taken by common citizens from banks and financial institutions. When the RBI increases the repo rate, banks have to pay higher interest on borrowing from the RBI. This increased cost gets passed on by banks to end consumers in the form of higher interest rates on home loans, auto loans, personal loans, and credit card dues. This increases the EMIs of retail borrowers.

Conversely, cuts in the repo rate translate into cheaper loans. Lower interest rates spur consumer spending and business investments. Thus, through its impact on prevailing interest rates in the economy, the repo rate affects the borrowing and spending power of the common citizen. It influences major financial decisions of individuals from buying homes and cars to financing higher education and personal needs. The overall cost of living and quality of life get impacted by RBI's repo rate.

How does this play practically in real life
 

Scenario 1: RBI increases Repo Rate
 

A hike in repo rate translates into more outgo for the banks as they will pay higher interest on the loans taken by them from RBI. This will also affect the rate of interest of their retail loans, which will go up, and the burden will fall on the end customer, i.e. borrower. The borrower will end up paying more interest, and their loan EMIs will become expensive.

Scenario 2: RBI lowers Repo Rate
 

As soon as the banks understand that RBI has reduced repo rates, they will be expected to follow suit and pass on the benefit to their customers. Since they will be in a better position to pay off their dues to RBI comfortably, they will also lower the interest rate charged to the borrower. Along with that, they are likely to increase the interest rate on deposits, resulting in increased income for their fixed deposit holders.

However, it is important to note that interest rate cuts and deposit rates hike are decisions that banks will take after considering the liquidity position or cash inflows and the demand for deposits from their customers.

What can a borrower do?
 

The potential borrower should act swiftly and immediately take a loan to gain lower interest rates. In the case of an existing borrower, the repo rate hike will ultimately lead to an increase in their monthly loan EMIs. In such a case, if the borrower can afford to pay off the loan, they should immediately do so.

By prepaying your loan, you will save yourself from a lot of interest payments since you would be paying up your principal amount on which interest accrues.

The borrowers must also ensure that their loan is linked to an external benchmark. This means that as soon as the rate of the external benchmark declines, the immediate benefit would pass on to the borrowers, depicting a decrease in the retail loan rates. The borrower should ask the lender to switch their loan to a loan linked to the external benchmark rate. If their lender does not offer this facility, they should consider switching to a new lender who does so.

To sum it up
 

Borrowers should stay updated with the latest repo rates declared by RBI, as has a direct bearing on their loan interest rates.

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