How Does Reverse Repo Rate Work?
Reverse Repo Rate is the key instrument of monetary policy of India that is used to control the supply of money in the economy. In this article, we will discuss what is Reverse Repo Rate in detail.
Role of RBI
- The Reserve Bank of India (RBI), being the central banking institution of the country, plays a pivotal role in the economy. As a Central Bank, Reserve Bank has the responsibility to control the monetary policy of Indian currency and maintain the adequate flow of credit in the economy.
- Reserve Bank determines how much money is to be made available to the economy and what should be the cost of that money. The availability of money indicates the liquidity position and the interest rate is the cost of using that money (also known as the cost of credit).
- Maintaining monetary stability in the Indian economy is the prime objective of the Reserve Bank and this is achieved by constant monitoring and stabilization of inflation.
- There are several financial tools involved in regulating the country’s monetary policy. Reverse Repo Rate is one of such tool used by the RBI to regulate money supply to India’s economic system.
What is Reverse Repo Rate?
- Reverse Repo rate is the interest rate at which Reserve Bank of India borrows money from the commercial banks by lending securities. This rate is a short term borrowing rate for RBI. If Reserve Bank of India requires to raise money, it approaches commercial banks for borrowing from them at a lucrative Reverse Repo Rate.
- When banks have excess funds, but don’t have any other lending or investment options, they deposit/lend the surplus funds with the RBI. This way banks can raise additional interest from their funds.
- In this way, RBI creates an opportunity for financial institutions and commercial banks to generate profit with a short term investment. Current Reverse Repo Rate is 5.75% (May 2019)
- Reverse Repo Rate is the functionally opposite concept to Repo Rate which works hand in hand to maintain the financial stability of our banking system and aid the growth of the economy.
How Does Reverse Repo Rate Work?
- Reverse Repo Rate is used to control the money supply in the system. Sometimes there will be surplus money in the market, which is a situation typically happens at the time of inflations. This results in the rise in price of all commodities and services resulting in the devaluation of money. In such situations, Central Bank will increase Reverse Repo Rate to discourage the Banks to lend money. Reserve Bank of India will take control of the economy using the various instruments like modifying the Reverse Repo Rate. Reverse Repo Rate enables RBI to absorb liquidity from the economy.
- An increased Reverse Repo Rate will reduce the money supply in the system, other factors remaining constant. If Banks have disposable funds that are remaining idle without deposit or investment opportunity, they can deposit such funds for a short term and earn interest. The interest rate that Reserve Bank will give the commercial banks for borrowing money from the banks is the Reverse Repo Rate.
- If Reserve Bank of India wants to restrict the availability of money in the system, they can increase the Reserve Repo Rate. This will provide incentive to the commercial banks to park more money with RBI resulting in less availability of the cash in the banking system and hence in the economy.
- Commercial banks will prefer to deposit their surplus with RBI for a short term since it is a completely risk free as compared to other riskier investments such as lending. Banks will be short of fund to provide credit to individual or institutional borrowers. This in turn will restrict the liquidity in the market.
- Due to reduced liquidity, the lending rates of commercial banks will go up leading to reduced demand for funds. This effect has the potential to control the market inflation. Also, from the perspective of commercial banks, if they have less funds available, they will be less involved in risky credit disbursement. So, increased Reverse Repo Rate provides some protection to the bank from credit risk.
- On the contrary, if Reverse Repo Rate is reduced, RBI gives an indication to the banks not to deposit their surplus funds with Reserve Bank any more. In such situation, banks will be more inclined to commercial lending to consumers at a cheaper interest rate. This will inject more liquidity in the system resulting in greater cash flow in the market.
Significance of Reverse Repo
- Reserve Bank of India has a framework for surplus funds/cash in the banking system which ensures there is no excess liquidity in the system. And this framework is referred to as reverse repo.
- Basically, repo transactions inject liquidity into the Indian banking system. On the other hand, reverse repo absorbs liquidity from the Indian banking system.
- The reverse repo rate has an inverse relationship with the money supply in the economy.
- During high levels of inflation in the economy, the RBI increases the reverse repo. It encourages the banks to park more funds with the RBI to earn higher returns on idle cash. As a result, every excess rupee is put to use in banking system. Banks are left with lesser cash to extend loans, curbing the purchasing power of individuals.
- RBI has to control the rate of inflation, supply of money in the economy and stimulate the economic growth. Thus, RBI has to strike a balance between both inflation, money supply and economic growth by revising the repo & reverse repo rate on a half yearly or quarterly basis.
- It is important for the country’s economic growth. And it’s equally important to avoid the higher rate of inflation in the country. This is where repo rate and reverse repo rate plays a crucial role by helping Reserve Bank of India strike a balance between both inflation and economic growth.
India’s Reverse Repo Rate Trend
Current Reverse Repo Rate is 5.75%, whereas the current Repo Rate is 6% as per the recent announcement in (April 2019) Bi-Monthly Monetary Policy by Monetary Policy Committee.