If you’ve ever come across financial news or discussions, you’ve likely heard the terms “repo rate” and “reverse repo rate” being thrown around quite frequently. These two rates play a crucial role in the Indian economy and directly impact various sectors, including banking, lending, and borrowing. While they may sound similar, repo and reverse repo rates are quite different and serve distinct purposes. In this article, we’ll break down these concepts and help you understand the critical differences between repo rate vs reverse repo rate.
What is the repo rate?
Before diving right into the difference between repo rate vs reverse repo rate, let’s first understand what they mean.
The repo rate, short for “repurchase rate,” is the rate at which the central bank (RBI) lends money to commercial banks in India. It is the interest rate charged by the central bank on the loans it provides to banks against securities like government bonds. When banks face a deficit of funds, they can borrow money from the RBI by selling these securities with an agreement to repurchase them at a later date.
Impact on interest rate – While the repo rate directly affects banks’ borrowing costs, its influence also extends to consumers. Banks adjust their lending rates, such as home and personal loan rates, based on changes in the repo rate. Therefore, fluctuations in the repo rate can affect the cost of borrowing for individuals and businesses.
How does the repo rate work?
When inflation rises, the RBI increases the repo rate, which is the interest rate that commercial banks must pay to borrow funds from the RBI.
A higher repo rate increases the cost for banks to borrow funds from the RBI. This impacts banks and their customers in two main ways:
– To compensate for the higher cost of borrowing, banks raise the interest rates they offer on deposits like savings accounts and fixed deposits. This allows them to attract more deposits and maintain sufficient cash reserves.
– Banks also increase their lending rates for loans and credits they provide to customers. Higher interest rates discourage borrowing and reduce the demand for loans. With fewer loans being given out, banks can maintain higher liquidity and control the money supply.
By making borrowing costlier through a higher repo rate, the RBI aims to reduce the amount of money flowing through the economy. This helps combat inflationary pressures by lowering demand and cooling down economic activity.
Current repo rate
The current repo rate in India is at 6.50%.
What is the reverse repo rate?
In repo rate vs reverse repo rate, the reverse repo rate is the rate at which the central bank (RBI, in India) borrows money from commercial banks. It is the interest rate paid by the central bank when banks deposit their surplus funds with the RBI. The reverse repo rate is usually lower than the repo rate.
Impact on interest rate – While the reverse repo date doesn’t directly influence lending rates as the repo rate does, it indirectly affects the overall interest rate environment. When banks earn higher returns by parking funds with the RBI at the reverse repo rate, they may be less inclined to lower their lending rates to consumers.
How does the reverse repo rate work?
The reverse repo rate functions as a monetary policy tool the central bank uses to control the amount of liquidity and money supply in the economy. The RBI can raise the reverse repo rate when it wants to reduce liquidity and control inflation.
This makes it more attractive for banks to park their excess cash reserves with the RBI to earn higher interest rather than lending them out. Removing this excess liquidity from the banking system has a contracting effect on the money supply and helps curb inflationary pressures.
Current reverse repo rate
The prevailing reverse repo rate in India is at 3.35%.
Distinction between repo rate vs reverse repo rate
The table below gives a comprehensive view of repo rate vs reverse repo rate.
Key difference between repo rate vs reverse repo rate
Feature
Repo Rate
Reverse Repo Rate
Lender
Reserve Bank of India (RBI)
Commercial banks
Borrower
Commercial banks
Reserve Bank of India (RBI)
Purpose
To provide funds to banks when they have a shortage.
To absorb excess funds from banks when they have a surplus.
Interest level
The interest rate is higher.
The interest rate is lower than the repo rate.
Interest charge mechanism
Banks pay interest to the RBI through a repurchase agreement using government securities as collateral.
The RBI pays interest to banks through a reverse purchase agreement using government securities as collateral.
Operational process
Banks borrow funds from the central bank by selling securities with an agreement to repurchase them back later.
Banks deposit excess funds with the RBI by lending money against securities to be repurchased later.
Impact on lending rates
A higher repo rate increases the banks’ cost of borrowing, leading to higher lending rates for loans.
A higher reverse repo rate incentivises banks to park more funds with the RBI, reducing money supply and loan growth.
Impact on money supply
A lower repo rate reduces the cost of borrowing for banks, increasing the money supply through higher lending.
A lower reverse repo rate makes it less attractive for banks to park funds with the RBI, increasing the money supply through higher lending.
To end
Understanding the difference between repo rate vs reverse repo rates is essential for individuals, businesses, and financial institutions, as these rates directly impact borrowing costs, lending rates, and the overall availability of credit in the economy.
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29 May 2024
5 mins read
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