What is Reverse Repo Rate?
Reverse repo rate is a ratio that is used by the Reserve Bank of India (RBI) to borrow money from other commercial banks. It is a financial instrument used to control the money flow in India’s market. A higher rate offers more incentive to commercial lenders to park their finances with RBI, decreasing the number of funds available in the market and vice versa.
Repo, or repurchasing option, is a powerful tool used to control a nation’s inflation and liquidity. The reverse rate also has a direct effect with the cost of borrowing; a higher reverse repo rate can decrease the funds used to extend loans directly affecting the spending power of the nation’s populace.
How Does Reverse Repo Rate Work?
Introduction of the repurchasing rate as a tool to fight inflation has helped the Indian economy by a significant margin. The Reserve Bank of India has introduced repo as the policy rate, the primary means to keep the currency flow in check and to stabilise prices in the open market.
The implementation of the reverse repo rate is completed in the following steps.
- Financial institutions lend their extra funds to the Reserve Bank of India for one day. It is considered as a one day loan by the financial institutions, and the Reserve Bank does not issue any securities (like treasury bills) against the funds.
- The Reserve Bank of India offers a rate of interest based on the reverse repo rate to that particular financial institution.
The reverse rate usually changes along with repo rate by equal percentage and in the same direction. RBI offers both repo and reverse repo information from Monday to Friday.
Difference between Repo Rate and Reverse Repo Rate
There are several differences between the repo rate and reverse repo rate. Let’s take a look at some of them –
- High repurchasing option reduces excess liquidity from the open market. Consequently, high reverse rates help inject necessary funds into the economy.
- Reverse repo rates usually stay lower than its counterpart.
- Reverse rates are utilised to control money flow in the market and help regulate inflation.
- The Reserve Bank of India acts as the lender while commercial financial institutions act as borrowers in case of repo rates. For reverse rates, the commercial financial institutions act as the lenders and RBI acts as the borrowers.
- Financial institutions receive funds from the RBI by hypothecating government bonds as collateral in case of repo, whereas RBI offers interest against the borrowed sum in case it is reverse repo rate.
The current reverse repo rate 2019 is 4.90% (as per RBI reports of 10th October 2019). It is an all-time low since the last 5 years, indicating an increased monetary flow in the domestic market.
Impact of Reverse Repo Rates in the Market
Repo rate and reverse repo rate are the prime components of the liquidity framework designed by the RBI. It helps manage surplus funds in the economy, ensuring there is no excess liquidity within. Financial institutions usually earn a higher rate of interest on the excess funds deposited to the Reserve Bank of India.
The impact of reverse repo rate cut reduces the earning potential of financial institutions when they park their finances with the RBI. It allows lending organisations to invest more in more lucrative investment options, increasing the overall fund’s availability in the Indian economy. It lowers the rate of interest for loans as well as increases the investments in avenues like the money market.
RBI’s Monetary Policy on the Reverse Repo Rate
The Reserve Bank of India modifies the reverse rate in accordance with several changing parameters in the macroeconomic overview. It was reduced recently for a record 5th time in a year to boost consumption and increase demand among customers.
There have been reports of a slump in demand in India, and there are several studies which have painted a bleak picture of GDP growth, IIP, exports, imports, and the fluctuating value of the rupee. All of these contribute to the macroeconomic outlook.
Since China is looking to strengthen its stronghold in Asia and the rest of the world, and with the tariff war brewing between China and the USA, the impact on an emerging economy like India is unprecedented.
The reverse repo rate was reduced by 25 basis points, taking it down to 4.90% from a previous high of 5.75%. The commercial rate applicable to financial institutions stands at 5.40%. It has helped restrain the Consumer Price Inflation (CPI) for the second half of the fiscal year (FY 2019-2020) at 3.5% to 4%.
The recent cut in the reverse rate is likely to increase consumer demand by a significant margin. Experts are predicting substantial growth in the demand for basic goods as well as advances from financial institutions throughout the nation.
Besides, the RBI is also taking advice from the Monetary Planning Committee to ensure their workings are in tandem.
The interest rates of financial products like personal loan, home loan, etc. are likely to decrease following a cut in the current repo rate in 2019. As lenders will have more funds to invest in the money market or lend more to their customers, they are likely to reduce the applicable rate of interest to entice prospective customers to take advances.
A reduction in the home loan interest rate will prompt prospective customers to borrow more money to purchase real estate. It will help the Indian economy by injecting funds into the real estate segment, which is witnessing an unseen slump and lending market.
Reverse rate is one of the most effective and efficient tools used to ensure market price stability and to boost economic development. These agreements help financial institutions manage their liquidity requirements and change their lending rates in accordance with the ups and downs of Indian financial market. It is also used as a parameter for short-term interest rate in the lending market.
