While discussing the RBI monetary policy, reverse repo rate and repo rate are two terms that are frequently tossed around. These are important terms that have a significant impact on the Indian economy. The Reserve Bank of India revises these rates from time to time to control the liquidity in the economy.
But what is the reverse repo rate? Let’s dive into it in detail and understand reverse repo rate meaning, its impact, importance, the current reverse repo rate in India, and changes in reverse repo rate in the previous years.
What is the reverse repo rate (RRR)?
As per the RBI monetary policy, the reverse repo rate is the rate at which the RBI borrows money from financial institutions. RBI uses this as part of its Liquidity Adjustment Facility (LAF) to reduce the liquidity in the economy. The Reserve Bank encourages lenders to park surplus funds with it to earn a higher interest.
At the prevailing reverse repo rate, RBI borrows money from lenders for 7 or 14 days whenever it needs funds. By regularly adjusting the RRR, the RBI controls the flow of cash in the system, boosting the national economy.
Who decides the value of the RRR?
The Reserve Bank of India’s Monetary Policy Committee (MPC), led by the RBI Governor, decides the current RRR in India. The committee conducts bi-monthly meetings to make such decisions.
What is the impact of the reverse repo rate?
Now that we know the reverse repo rate meaning let’s understand what happens when the rate increases or decreases.
- Increase in RRR
By increasing the reverse repo rate, RBI encourages financial institutions to lend more money and earn more interest on the surplus funds. When financial institutions park this money with the RBI, it reduces their lending activities, further reducing market demand. This way, RBI removes excess liquidity from the banking system. Increasing RRR is part of RBI’s contractionary or tight monetary policy.
- Decrease in RRR
The RBI decreases the reverse repo rate to infuse liquidity in the economy and increase market demand. When the RRR decreases, lenders earn less interest on the money deposited with the Reserve Bank. This encourages them to lend money to customers instead of the RBI. Decreasing RRR is RBI’s expansionary or loose monetary policy.
In what way is the reverse repo rate important?
In line with RBI’s monetary policy, the reverse repo rate ensures that there is no lack or surplus of cash in the system. Here’s why the RRR is an important aspect of the economy-
- Controls inflation
When the rate of inflation increases, the RBI increases the RRR to attract lenders to deposit surplus funds with it. This tactic helps in controlling inflation by reducing the money supply in the economy. On the other hand, when the RBI fears that a lack of cash flow can slow down the economy, it decreases the RRR. This improves the lending activities of financial institutions, thereby boosting the economy.
- Impacts interest rates on loans
Lenders extend affordable credit when RBI decreases the reverse repo rate, meaning you can enjoy lower interest rates on loans. This is because lenders can earn more interest by lending money to customers instead of the RBI. On the other hand, when RRR increases, the interest rate on loans will also increase as lenders will extend credit only if they earn higher profits.
- Boosts currency strength
When financial institutions park surplus funds with the RBI instead of extending loans to customers, it reduces the money supply in the banking system. When this happens, it increases the strength of the rupee. Similarly, with a surplus cash flow in the system, the strength of the rupee decreases.
Why is the reverse repo rate lower than the repo rate?
Have you noticed that the interest you pay on loans is higher than the interest you receive on your savings account? Well, the same principle applies to financial institutions as well.
The rate at which lenders borrow money from RBI is called the repo rate. This rate is higher than the reverse repo rate, meaning lenders pay more interest on the money they borrow from RBI and receive a lower interest on the excess cash they deposit with the RBI. The difference between the current reverse repo rate and repo rate helps the RBI to earn profits.
The current reverse repo rate in India
The Reserve Bank of India decreases financial liquidity from lenders against collateral using the reverse repo rate, meaning it accepts overnight deposits from lenders against qualified government assets as security. The current reverse repo rate in India is 3.75%. For almost two years, the RRR has been 3.35%.
What is the reverse repo rate trend in India?
The RRR updates by the Reserve Bank of India in the last few years are-
|Month of change of repo rate||Reverse repo rate|
|May 2019||5.75 %|
|June 2019||5.50 %|
|August 2019||5.15 %|
|October 2019||4.90 %|
|March 2020||4.00 %|
|April 2020||3.75 %|
|May 2020||3.35 %|
|May 2022||3.75 %|
To wrap up
The reverse repo rate is an essential tool to control the banking system and economy of the country. The RBI regularly modifies this rate to maintain the flow of money in the system and keep a check on inflation. In times of an economic setback like the COVID-19 pandemic, the Reserve Bank of India lowers the RRR to promote lending and restore financial balance. Now that the economy is gradually recovering, the RBI has increased the RRR to reduce the gap between repo and reverse repo.
It is important to understand what is reverse repo rate as it has a direct impact on the interest rates of your loan. When the RBI decreases the RRR, financial institutions also decrease the interest on loans and vice versa. This is to encourage borrowers to avail of credit and increase the liquidity in the market. This makes reverse repo an important factor while determining your loan interest rates.