I was sitting with my friend Raju one fine evening, when he stared at me for a long duration before asking, “You are a commerce graduate right? Can you tell me what exactly is the difference between repo rate and reverse repo rate? My teammates often discuss about it and I am standing clueless in front of them, nodding my head with hands in my pocket.”
Just like Raju, many of us don’t get the two terms. Sure, you can Google it instead of asking your commerce friend, but you will find Google will also give you standard statements and not a thorough understanding of it.
There is a long list of words in business newspapers that don’t make sense to you. There are a lot of terms you have a vague idea about, but not really sure about what they exactly mean and how they affect you.
The purpose of this article is to cover two such words- Repo rate and reverse repo rate. We have all heard these words when Reserve Bank of India (RBI) holds quarterly review meetings. We also hear them when the policymakers justify certain economic decisions. And we know that whenever these words are used frequently in newspapers and news channel discussions, our loan rates, deposit rates are set to change- for better or worse.
So let’s pick these terms one by one and try to understand them. Just like Raju, I will keep it super simple for you to get a hold of the concept.
What is Repo Rate?
Suppose you are State Bank of India. You receive a proposal from a big business for a loan of Rs 1000 crore. The proposal is good, and you want to give them the loan. But due to recent losses, your liquidity isn’t as good- meaning that you have the amount, just not available for lending immediately- some of it is in advanced out for other loans etc. you have a loan demand of Rs 1000 crores, but you have only Rs 800 crore in your liquid assets.
But the proposal is so good you can’t let it go. So what do you do, you go to your central bank- The Reserve Bank of India. You borrow some money (Rs 200 crore) from RBI in order to fulfill your short term demand.
Of course, RBI will not give you this money for free. It will charge interest from you for this loan that it is going to give you.
The rate at which a central bank (RBI) lends money to a commercial bank (here SBI) is called the repo rate.
What is the full form of repo rate?
Derived from the name itself, Repurchase rate is the full form of repo rate.
Now some of you might wonder why repurchase? Let us understand this also.
When RBI lends money to SBI, like in the previous example, it will not do so without any security. Here RBI insists on a very particular security- Government bonds. RBI enters into an agreement with the bank- that the bank will pledge the securities with RBI for the loan amount, and buy back at the future date at a pre-determined future price. The repo rate here will determine how much more will the bank (SBI) pay to RBI for the same security while repurchasing them in future.
What is Reverse Repo Rate?
Reverse repo rate is as simple as the name suggests- the complete opposite of repo rate.
In the above example, let us suppose SBI has excess liquid money. It means that the demand for loans is less, and inflow of money in the form of savings is more for the bank. Now what will SBI do with the excess money? It can invest it somewhere, but investing in long term plans might mean less liquid options for SBI.
So it parks the excess funds with RBI for short term. Again, it will not give these funds to RBI free of cost, rather charge a rate of interest. That rate of interest is the reverse repo rate.
The rate at which a central bank parks money for a bank is called reverse repo rate.
What is the difference between repo rate and reverse repo rate?
Although the above example of SBI and RBI in two different scenarios makes it abundantly clear, the following table will help you to understand the difference between repo rate and reverse repo rate.
|Repo Rate||Reverse Repo Rate|
|Charged by RBI from banks||Charged by banks from RBI|
|Used to control inflation||Used to control money supply|
|Always higher than reverse repo rate||Always lower than repo rate|
There are more differences between the two, in case of their usage and effect on the economy, let us discuss them ahead.
How does repo rate affect the economy?
Repo rate and reverse repo rate are often called money market instruments.The central bank (RBI) uses these instruments to control the supply of money in the economy in order to meet its economic objectives.
Let’s make it simpler.
Suppose the market is down. Interest rates are very high- you want to buy a house but rate of interest is very high for you to afford.
Banks also want to lend more but due to their cost of lending, they cannot lower their rate of interest any further.
RBI wants to solve this for you. It lowers the repo rate. Now banks can borrow any excess money they need, from RBI at a lower rate of interest.
Since they are getting money at low rate of interest, they are able to lend it to you at a lower rate of interest as well.
Now you see the rate of interest has come down, and you can finally afford a house loan and its EMIs.
This is how RBI uses repo rate to increase demand in the economy- lower rate of interest boosts spending by the people- since loan rates are low, they don’t hesitate to take credit to buy new things- cars, houses, even consumer goods.
RBI can use the opposite of this as well.
If RBI feels there is too much money in the market and
- Banks are lending too much
- or People are buying too much
which is increasing inflation and driving up prices- RBI increases the repo rate. Now since banks’ cost of borrowing has increased, it will pass on the cost to you. So the house you were happy to buy with a loan suddenly becomes difficult due to increase in rate interest.
What is the current repo rate and reverse repo rate in 2018?
The current repo rate is 6.25 %
The current reverse repo rate is 6 %
Why reverse repo is less than repo rate?
Repo Rate and Reverse repo rates are essentially rates at which RBI lends and borrows money. And just like any bank, it will lend at a higher rate than the rate at which it borrows- in order to maintain a positive spread for itself.
Suppose you are a bank. You borrow from A and lend the same money to B. now, in order to make money in these two transactions, you have to charge more money from B, and pay less than that to A- simple business logic.
Here, what you pay to A is reverse repo rate, and what B pays you is reverse repo rate.
Why the difference between repo rate and reverse repo rate is always 1 ?
There used to be a stable difference of 1 % between both these rate since 2011, but that norm has been done away. Now at present there is a difference of only 25 basis points between the two rates.
The difference of 1 % was not mandatory but was announced as a rule in 2011 by RBI because of mainly two reasons
- Reverse repo rate will be linked to Repo rate and not announced separately
- A fixed spread will ensure clear policy message in the market
What is bank rate? Is it different from Repo rate?
Bank rate is very similar to repo rate, so pay attention otherwise it can get confusing.
Bank rate is the rate which RBI charges from banks to borrow money from it.
Wait, that’s what Repo rate was, right?
Well, yes and no.
Repo rate, that is, repurchase rate focuses on buying back government securities from RBI at a pre-determined rate. The key word here is repurchasing. There is a collateral here- the government securities.
On the other hand, in bank rate, there is no security with RBI as the focus here is on loan. That’s why you will find repo rate is slightly lower than Bank rate.
So, although both of them serve the same purpose, they are slightly different in terms of their execution.
Current Bank rate is 6.25 %
Why repo rate is called as policy rate?
Repo rate is often called a policy rate. That’s because it helps RBI achieve its monetary policy objectives- controlling inflation, increasing demand etc.
RBI observes the economy is slowing down due to less spending by people; it will lower repo rates and make loans cheaper.
In some other quarter, RBI observes inflation is getting out of hand. So it increases repo rate in order to make loans costlier, subsequently driving down demand.
Next time you see your home loan rate of interest increasing after an RBI policy review meeting, you will be in a better position to guess what rates they have tweaked, and in what direction.
So, what is your view on repo rate and reverse repo rate? Have you understood the difference between repo rate and reverse repo rate?