What is Repo Rate?

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The repo (repurchase) rate, also known as the benchmark interest rate, is the rate at which the Reserve Bank of India (RBI) lends money to commercial banks for a short term, typically a maximum of 90 days. The repo rate is a key monetary policy tool used by the RBI to control liquidity and inflation in the economy.

How the Repo Rate Works?

  • When banks need short-term funds, they can borrow from the RBI through a repurchase agreement.
  • In a repo agreement, banks use government securities as collateral to borrow funds from the RBI.
  • The repo rate is the interest rate that banks pay to the RBI on the borrowed funds.

Impact on Borrowing Costs

    • When the RBI increases the repo rate, borrowing from the RBI becomes more expensive for banks. Conversely, when the RBI reduces the repo rate, borrowing costs decrease, making it cheaper for banks to obtain funds.
    • An increase in the repo rate discourages banks from borrowing, as it raises their operational costs, while a decrease in the repo rate encourages borrowing, promoting economic activity.

    Mechanism of Borrowing

      • Banks borrow money from the RBI by pledging government securities as collateral. This transaction occurs through a repurchase agreement.
      • For example, if a bank wants to borrow ₹1 billion, it must provide government securities worth at least ₹1 billion (considering a margin requirement of 5%–10% of the loan amount) and agree to repurchase them at ₹1.07 billion at the end of the borrowing period. In this scenario, the bank pays ₹70 million as interest, illustrating why it is called the repo rate.

      Collateral Requirements

        • The government securities provided as collateral cannot come from the Statutory Liquidity Ratio (SLR) quota, as using these would reduce the SLR below the mandatory 19.5% of Net Demand and Time Liabilities (NDTL), attracting penalties.

        Role of the Repo Rate in Controlling Inflation and Deflation

        Curbing Inflation

          • To control inflation, the RBI increases the repo rate, making borrowing costs higher for banks. Banks, in turn, raise the interest rates for their customers, making loans more expensive. This reduces the number of people applying for loans, decreasing aggregate demand and thus lowering inflation.

          Fighting Deflation

            • To combat deflation, the RBI decreases the repo rate, lowering borrowing costs for banks. This encourages banks to reduce their lending rates, making loans cheaper and boosting borrowing and spending in the economy, which helps to increase aggregate demand.

            Repo Rate vs Base Rate

            • It is important to distinguish between the repo rate and the base rate.
            • The repo rate is the rate at which the RBI lends to banks, while the base rate is the minimum interest rate at which banks lend to their most creditworthy customers.
            • While a change in the repo rate can influence the base rate, banks are not legally obligated to change their base rate in response to a change in the repo rate.
            • Even when the RBI reduces the repo rate, banks are not legally required to reduce their own base rates immediately. The decision to adjust lending rates depends on various factors, including the banks’ cost of funds and market conditions.

            By managing the repo rate, the RBI influences overall economic activity, aiming to maintain price stability and support economic growth.