Repo rate is a powerful tool used by India’s central bank, the Reserve Bank of India (RBI), to maintain liquidity in the market and manage cash flow. The Monetary Policy Committee (MPC) of the RBI convenes bi-monthly to make changes to the repo rate according to economic conditions. It can be used to combat inflation, recession, induce cash flow, increase investment, etc. A hike or slash in the repo rate can have significant impacts on the economy, particularly the cost of borrowing credits. Thus, you must be aware of this term and what it implies for you as the borrower.
What is Repo Rate?
The repo rate is the rate at which commercial banks borrow from the RBI by selling security such as Treasury Bills to the central bank. Just like you, the borrower, borrow money from the bank by providing collateral and repaying the amount with an interest rate, commercial banks can also borrow money from the RBI in case of a cash crunch.
Here, the collateral is the Treasury Bills that commercial banks sell to the RBI, and the interest rate of borrowing is called the Repo Rate. However, the repo rate does not just affect the borrowing banks; it also affects the ordinary citizens of society.
The relationship between repo rate and interest rates
The relationship between the repo rate paid by the bank to RBI and the interest rates paid by the borrower to the bank is directly proportional. The greater the repo rate, the higher will be the cost of borrowing. Let us understand this with two examples.
Scenario #1: RBI hikes repo rate
As of December 2020, the repo rate was 4%. Suppose that RBI increases this to 6%. This means that now, the cost of borrowing from the RBI has increased by 2% or 200 basis points for commercial banks. To compensate for a high cost of borrowing, banks will, in turn, charge a higher interest rate from their borrowers. As a result, loans will become expensive for citizens.
Scenario #2: RBI slashes repo rate
Alternatively, if the RBI slashes this rate from 4% to 3.75%, banks will be able to afford borrowing more easily than before. They will reduce the interest rates for loans and taking a loan from the bank will become cheaper for citizens.
In addition to affecting the interest rates on loan, the repo rate also impacts the returns on direct deposits. If there is a repo rate cut, you will earn a lower interest rate and vice versa.
Additional Read: How a change in repo rate impacts your loan EMIs
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