What is Repo Rate & How it Works?

Ever wondered what is repo rate and how it impacts your wallet? Don’t worry; you’re not alone. Repo rate is one of those economic terms that sounds complicated but is actually quite straightforward once you understand it. It determines how much interest your bank charges for loans and how much interest you earn on your savings/deposits.

Let’s learn more about repo rates and how it impacts borrowers and investors.

What is Repo Rate?

The repo rate represents the interest rate at which commercial banks can borrow funds from the Reserve Bank of India in case they face a shortage of funds. 

The repo rate impacts us in the following ways:

• It determines the interest rates that banks charge on loans and pays on deposits. If the repo rate increases, banks will raise interest rates on loans and deposits. If it decreases, banks will reduce interest rates. As such, the higher the repo rates, the higher interest you pay on loans and earn in your savings/deposits. The lower the repo rate, the cheaper loans get, but the less interest your savings earn.
• It influences the availability of money in the economy. An increase in the repo rate makes borrowing from the central bank more expensive for commercial banks. Consequently, banks borrow and lend less, resulting in a reduction in the money supply. Conversely, when the repo rate decreases, the opposite effect occurs.
• It impacts inflation and economic growth. An increase in the repo rate helps control inflation but slows down economic growth. Decreased repo rates spur economic growth but can lead to higher inflation.

The central bank considers factors like inflation, economic growth, global economy, etc., before changing the repo rate. For example, if global interest rates rise, the central bank may also increase the repo rate to prevent money from flowing out of the country.

The repo rate in India has seen many ups and downs since it was introduced in the 1990s. It was as high as 9% in 2008-09 during the global financial crisis but has declined since then. The current repo rate in India is 6.5%.

Calculation of Repo Rate by the Reserve Bank of India

The Reserve Bank of India (RBI) sets the repo rate based on the current economic conditions, such as inflation or recession. Acting as the central bank of the country, the RBI plays a key role in regulating the economy, and the repo rate is an integral part of this process. The percentage of the repo rate is adjusted by the RBI according to the prevailing economic scenario.

Example of Repo Rate Calculation:

Suppose a nationalised bank, XYZ, requires ₹20,000 in funds. To obtain this amount, XYZ approaches the RBI and borrows the money by providing bonds and securities as collateral. XYZ bank must offer bonds worth ₹20,000 as security to receive an equivalent amount in cash.

The RBI charges a 5% interest rate on these bonds, known as the repo rate. This 5% will amount to ₹1,000 in interest. When XYZ repays the borrowed amount, it will return ₹21,000 to the RBI, comprising the original ₹20,000 plus ₹1,000 as interest, and will receive its bonds back.

Repo Rate Table

This is a list of all the repo rates over the past decade

Key Components of the Repo Rate

The repo rate plays a vital role in managing inflation, liquidity, and the overall money supply in the country. It directly influences how banks borrow funds and help maintain financial stability. Before approving loans to banks, the Reserve Bank of India (RBI) adheres to specific standards, with the repo rate being a key element. The main components of the repo rate include:

• Inflation control The repo rate helps manage inflation by adjusting borrowing costs. The RBI increases or decreases the rate based on the economic situation to keep inflation in check and stabilise the economy.
• Hedging and leveraging The RBI engages in hedging and leveraging activities by purchasing security bonds from commercial banks and financial institutions, influencing the financial markets.
• Short-term borrowing The RBI provides short-term loans, often with an overnight tenure. Once the tenure ends, the borrowing bank repurchases its collateral by repaying the loan amount.
• Collateral and security For loans, the RBI accepts bonds and gold as collateral, ensuring secure lending practices between the central bank and commercial banks.
• Liquidity and cash reserves Banks borrow from the RBI to maintain liquidity and sufficient cash reserves, ensuring financial security and smooth operations.

How Does Repo Rate Impact You as a Consumer?

Now that you know what the repo rate is, let’s look at how it impacts you. When the repo rate increases, banks have to borrow money at a higher cost. To offset this increased cost, banks typically increase their own lending rates like home loan and personal loan rates. This means EMIs on your loans go up, and new loans become more expensive.

On the flip side, banks can borrow money at a lower cost when the repo rate is cut down. This allows banks to reduce their lending rates, making loans cheaper for you. Your EMIs decrease, and new loans become more affordable.

The RBI monitors the repo rate closely and makes changes based on the economic situation. When the economy slows down, the RBI may cut the repo rate to make it easier for people to borrow money and boost spending. When inflation is high, the RBI may increase the repo rate to tighten the money supply in the system.

Keep an eye on the RBI’s policy reviews to see if there are any changes in the repo rate. While a rate cut may seem exciting, a hike could significantly impact your budget if you have floating-rate loans. Be prepared for both scenarios!

The Global Economy’s Influence on Repo Rates

Economic conditions around the world influence the repo rate in India. When global growth is strong, demand for Indian exports increases. This boosts India’s economy, and the RBI will often raise the repo rate to avoid high inflation. On the other hand, when the global economy slows down, demand for Indian exports declines. This can weaken India’s economic growth, so the RBI will usually lower the repo rate to encourage more borrowing and spur growth.

For example, during the global financial crisis of 2008, central banks worldwide cut interest rates to revive their economies. The RBI also slashed the repo rate in India to boost liquidity. In contrast, when the global economy was booming in the mid-2000s, the RBI hiked the repo rate multiple times to curb rising inflation in India, fueled by strong domestic demand and high oil prices.

Global commodity prices, especially oil prices, also impact India’s repo rate. India imports over 80% of its crude oil needs. When oil prices rise sharply, it fuels inflation in India, and the RBI raises rates. Falling oil prices, on the other hand, help lower inflation and allow the RBI to cut rates to support growth.

The policies of major central banks like the US Federal Reserve and European Central Bank influence the RBI’s decisions. If the US Federal Reserve hikes rates, it often strengthens the US dollar. This can lead to capital outflows from India and weaken the rupee. The RBI may raise rates in response to prevent the rupee from depreciating too quickly. Conversely, if the US Federal cuts rates, it can boost capital inflows into India, allowing the RBI to lower rates.

A Brief History of Repo Rates in India

The Reserve Bank of India (RBI) has been adjusting the repo rate in India since the early 1990s to influence the country’s economy:

• A Tool for Economic Growth: In the 1990s, India began liberalising its economy. The RBI started using the repo rate as a tool to spur business investment and consumer spending. As the economy grew rapidly, the RBI increased the repo rate to curb inflation. 

• Responding to Global Financial Crisis: When the global financial crisis hit in 2008, the RBI cut the repo rate aggressively from 9% to 4.75% over a few months. This made it much cheaper for banks to borrow money, allowing them to lower interest rates for consumers and businesses. This helped cushion the economy during a period of weak global demand.

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Conclusion

The repo rate is a powerful tool that the RBI uses to influence India’s economy. The RBI calibrates the repo rate based on economic conditions, often in response to what’s happening in India and around the world. For consumers, the repo rate is about how much they pay for a home or auto loan. So next time the RBI announces a change, you’ll know why it matters!

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