Repo Rate and Reverse Repo Rate, its Impact on Economy

Context: The Monetary Policy Committee (MPC) decided to keep the repo rate stable at 6.5%, focusing on withdrawing accommodation gradually to ensure inflation does not accelerate while still supporting economic growth.

Repo Rate Latest Updates

The Reserve Bank of India (RBI) updated its GDP growth projection for the fiscal year 2024-2025 to 7.2%, up from the previous estimate of 7%. The GDP growth rates for the quarters in 2024 are projected as follows:

• Q1: 7.1%
• Q2: 7.2%
• Q3: 7.3%
• Q4: 7.2%

Reasons for Maintaining the Repo Rate

• Persistent Inflation: Inflation has remained above the 4% target, declining only gradually, which reflects the “stickiness” of inflation.
• Sustainable Targeting: The RBI requires sustained evidence that inflation will consistently align around the 4% target before considering rate adjustments.
• Strong GDP Growth: India’s GDP growth has been robust, exceeding 7% annually over the past four years, which suggests limited need for economic stimulation via repo rate cuts.
• Fiscal Policy Considerations: The upcoming Union Budget and its potential impact on fiscal deficit and monetary policy are also factors influencing the decision to maintain the repo rate.

Repo Rate and Reverse Repo Rate

• Repo Rate: The interest rate that the RBI charges when commercial banks borrow money from it is called the repo rate.
• Reverse Repo Rate: The interest rate that the RBI pays commercial banks when they park their excess cash with the central bank is called the reverse repo rate.

Repo Rate Objectives

Inflation

By raising the Repo Rate, the Repo Rate is utilized as a tool to manage inflation. The RBI works hard to stop the flow of money into the economy when there is high inflation. Increasing the repo rate is one way to do this. As a result, borrowing becomes more expensive for enterprises and industries, which slows market investment and money supply. It consequently has a detrimental effect on economic expansion, which helps to keep inflation under control.

Liquidity

Based on the macroeconomic circumstances, the Repo rate is adjusted to raise or decrease liquidity to change the demand in the economy. On the other hand, the RBI reduces the repo rate when it has to infuse money into the system. As a result, businesses and industries can borrow money for a variety of investment goals at lower rates. The whole money supply of the economy is likewise increased. In turn, this accelerates the rate of economic growth.

Components of Repo Rate

• Preventing “squeeze” in the economy: As a result of inflation, the central bank modifies the Repo rate. As a result, it aims to steer the economy via containing inflation.
• Hedging and Leverage: The RBI attempts to leverage and hedge by buying assets and bonds from banks and giving money in exchange for deposited collateral.
• Short-Term Borrowing: The RBI provides short-term loans, up to an overnight period, following which banks buy back their deposited securities at a set price.
• Collateral and Securities: Gold, bonds, and other types of collateral are accepted by the RBI.
• Cash Reserve or Liquidity: As a precaution, banks borrow money from the Reserve Bank of India (RBI) to maintain liquidity or cash reserves.

Impact of Repo Rate on Economy

• Decrease in Repo Rate: When the RBI wants to encourage economic activity in the economy, it reduces the repo rates.
  • Doing this enables commercial banks such as the SBI to bring down the interest rates they charge (on their loans) as well as the interest rate they pay on deposits.
  • This, in turn, incentivises people to spend money, because keeping their savings in the bank now pays back a little less, and businesses are incentivised to take new loans for new investments because new loans now cost a little less as well.
• Increase in Repo Rate: RBI tries to control inflation in the economy by increasing the repo rate. By doing this, it makes borrowing a costly affair for businesses and industries and this in turn slows down investment and money supply in the market. It eventually and negatively impacts the growth of the economy, which helps in controlling inflation.

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Monetary Policy

• Monetary and credit policy in India refers to the set of tools and measures used by the Reserve Bank of India (RBI) to influence the overall money supply, interest rates, and credit flow in the economy.
• It is published by the RBI’s Monetary Policy Committee.
• Expansionary Monetary Policy: It involves increasing the money supply in an economy, usually implemented by lowering key interest rates to boost economic activity.
  • The Reserve Bank of India (RBI) may reduce policy rates like Repo, Reverse Repo, MSF, and Bank Rate. This leads to increased bond prices, lower interest rates, and enhanced capital investment.
  • Domestic bonds become less attractive, reducing the demand for domestic currency and lowering the exchange rate.
  • This boosts exports, reduces imports, and improves the balance of trade.
• Contractionary Monetary Policy: It aims to decrease the money supply, often by raising key interest rates, which can slow economic growth. When RBI adopts this policy, it increases policy rates.
  • This results in decreased bond prices and higher interest rates, leading to reduced capital investment.
  • Domestic bonds become more attractive, increasing the demand for domestic currency and the exchange rate.
  • Consequently, exports decrease, imports increase, and the balance of trade diminishes.

Liquidity Adjustment Facility (LAF)

• It is a monetary policy tool used by central banks, including the Reserve Bank of India (RBI), to manage liquidity in the banking system.
• This facility is primarily employed to influence short-term interest rates and maintain stability in the financial markets.
• The Liquidity Adjustment Facility (LAF) operates through two main components Repo Rate and Reverse Repo Rate.

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