What are repo rate & reverse repo rate?

Repo rate and reverse repo rate are financial tools that are used by the central bank of a country to manage liquidity, control inflation and induce stability in the economy.

What is repo rate?

It is the interest rate at which the central bank lends to commercial banks for their short-term funding needs. In India’s case, it is the Reserve Bank of India (RBI) from which commercial banks borrow by offering a collateral of securities such as treasury bills and government bonds. These securities are later ‘repurchased’ by the commercial banks at a predetermined price and time. Repo is derived from the terms ‘repurchase agreement’ or ‘repurchase option’ to buy back securities kept as collateral with the RBI.

The repo rate is fixed by the monetary policy committee (MPC) of the RBI depending on the prevailing economic conditions and macroeconomic factors. The current repo rate is 6.5% and has remained unchanged since February 2023.

Impact of repo rate

Managing inflation
The repo rate is increased or decreased to adjust liquidity and control inflation. When inflation is high, repo rate is raised to discourage borrowing by businesses, reduce investment activity and spending. This helps restrict the flow of cash in the economy and curbs inflation.

Liquidity & economic growth
Lower repo rates can increase liquidity and spur economic growth because it encourages borrowing by businesses, which leads to an increase in investment and spending.

Lending rates
Repo rate also acts as a benchmark for lending rates by banks. A higher repo rate leads to an increase in interest rates for home loans, which translates to higher EMIs for borrowers. At the same time, it leads to a rise in the deposit rates, encouraging savings.

What is reverse repo rate?

As the term suggests, it is the reverse of repo rate and is the rate that the RBI pays commercial banks for depositing their surplus funds with it for the short term. The reverse repo rate is always lower than the repo rate because lending rates are always higher than deposit rates. It is the spread or difference between lending and deposit rates that helps the RBI earn profits.

The current reverse repo rate, as fixed by the RBI, is 3.35%.

Impact of reverse repo rate

Managing liquidity & inflation
A rise in reverse repo rate encourages banks to deposit their funds with the RBI instead of lending to borrowers. This sucks the liquidity out of the system, leading to a drop in inflation.

Lending rates
An increase in reverse repo rate leads banks to raise their lending rates to increase their own profits, making loans more expensive and raising the EMIs. It also increases the deposit rates.