How Does Repo Rate Work?

Introduction

Repo rate is the key instrument of monetary policy of India that is used to control the inflation in the economy. In this article, we will discuss what is Repo Rate in detail.

What Is Monetary Policy?

  • Monetary policy refers to the policy formulated by Reserve Bank of India for the purpose of controlling monetary supply and rate of interest/cost of money in the economy to stimulate the growth. 
  • Thus, RBI formulates the monetary policies and executes them to achieve a few specific objectives regarding the inflation and growth of the economy.
  • The primary objectives of such monetary policies are : promoting economic development through price stability, regulation of the volume of bank credits, improving efficiency of the financial system, promoting investments and reducing the rigidity to encourage diversification etc.
  • Repo rate and reverse repo rate are the key instruments of monetary policy of India that are used to control money supply in the economy.

What is Repo Rate?

  • Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds. The lending here is overnight lending.
  • Legal Definition : Repo means an instrument for borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed;
  • Repurchase Options or Repo, is a money market instrument, which enables collateralised short term borrowing and lending through sale/purchase operations in debt instruments. Collateralised here means collateral based or security based or guarantee based.
  • This is an instrument used by the RBI and banking institutions to manage their daily / short term liquidity.
  • At present Policy Repo Rate in India is 6%, which means RBI will lend overnight to any bank at an interest rate of 6%.
Repo Rate Transaction
Repo Rate Transaction

For Example :

  • Bank A is taking a loan of Rs.100 Crores from RBI for 1 day and putting Government Bonds of same value as security with a promise that they will buy these government securities back after 1 day. After one day, Bank A return (Rs.100 Crores + interest amount) to RBI and get back his securities.
  • So this is a Repo transaction from side of Bank A. The securities transacted here can be either government securities or corporate securities or any other securities which the RBI permits for transaction.
  • The duration between the two transaction which was 1 day in our example is called the ‘repo period’. Predominantly, repos are undertaken on overnight basis, i.e., for one day period.
  • Repo is thus, a money market instrument combining elements of two different types of transactions viz., lending-borrowing and sale-purchase.

HOW DOES REPO RATE WORK?

  • When you borrow money from the bank, they charge an interest on the principal. Basically, it is cost of credit. Similarly, banks too can borrow money from RBI during cash crunch. So they must pay pay interest on the amount borrowed to the Central Bank.
  • Thus, If a bank needs money in short span of time, it contacts RBI and asks for overnight lending. RBI lends the bank the required fund at an interest rate called REPO RATE.
  • Technically, Repo stands for ‘Repurchasing Option’. It is a contract in which banks provide eligible securities such as Treasury Bills to the RBI while availing overnight loans.
  • An agreement to buy them back at a predetermined price will also be in place. So, this interest rate is levied on these kinds of repo transactions as well. 
  • At present Policy Repo Rate in India is 6%, which means RBI will lend overnight to any bank at an interest rate of 6%.
Repo Rate Trend of India
Repo Rate Trend of India

What Are the steps of A Repo Transaction?

 Steps of a repo transaction between the RBI and the bank are as follows:

  1. Banks provide eligible securities (RBI-recognized securities that are above the Statutory Liquidity Ratio limit).
  2. RBI gives 1 day or overnight loan to the bank.
  3. RBI charges an interest (repo rate) from the bank.
  4. Banks repay the loan after one day and repurchase the security they gave as collateral.

for what purpose RBI uses the Repo rate?

RBI controls the monetary contraction and expansion through repo rate, which in turn help it control inflation.

What does monetary expansion and monetary contraction mean?

  • When RBI wants the supply of money to increase in the market, it increases the circulation of currency in the economy. It is termed as Monetary Expansion.
  • Similarly, when RBI wants to reduce the supply of money in market, it decreases the circulation of currency in the economy. It is called Monetary Contraction.

How does RBI uses Repo rate as a tool to control monetary contraction and monetary expansion and finally inflation?

  • Suppose there is inflation in the economy, central banks would increase repo rate.This acts as a disincentive for banks to borrow from the central bank.
  • This ultimately reduces the money supply in the economy (monetary contraction) and thus helps in arresting inflation.
  • Similarly, if RBI wants to increase inflation, central bank takes the contrary position.

Significance of Repo Rate

  • Since repos are attached with a repurchase agreement it makes the repo instrument almost non risky as there is no doubt about the liquidity of the security given as collateral since the borrower himself is willing to buy back the security and even if he doesn’t, the securities are high grade debt instruments which can be easily be traded.
  • Due to this Repo transactions have mostly replaced the non-collateralised borrowing (call loans) in the market.
  • Repo helps banks to maintain their CRR and SLR ratios on daily basis. A Bank who needs cash to maintain CRR, goes in repo transaction and acquires cash in place of securities and the bank who needs govt securities to maintain SLR, goes in reverse repo transaction to acquire Govt securities and parts with cash.
  • Repo rate is an Liquidity management tool in the hand of RBI as Repo rate act as benchmark rates for the economy. When RBI wants to increase interest rates in the market and decrease liquidity, it increases Repo/reverse repo Rates and vice versa.

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