De-jargoned | Repo and reverse repo rate

De-jargoned | Repo and reverse repo rate

In its third quarter review of the monetary policy 2010-11 announced on Tuesday, the Reserve Bank of India (RBI) increased key policy rates. RBI has raised the repo rate and the reverse repo rate 25 basis points (bps) each. One basis point is one-hundredth of a percentage point. Let’s see what these rates are and what they mean for you.

Repo Rate

What is it: When commercial banks face shortage of funds, they can borrow from RBI to fill the gap. The rate at which the apex bank lends these funds to banks is called the repo rate, or repurchase rate. The banks borrow for short periods.

How it’s done: RBI buys government bonds from banks and agrees to sell them back to banks at a fixed rate. When RBI reduces the repo rate, banks get money at a cheaper rate. When RBI increases the repo rate, borrowing from RBI becomes more expensive.

Until 24 January, the repo rate was 6.25% per year, but RBI hiked it by 25 bps to 6.50%. This means that currently if the banks have to borrow funds from RBI, they will have to pay an interest rate of 6.50% for those funds.

Reverse Repo Rate

What is it: Simply put, it is the opposite of repo rate. The interest rate at which RBI borrows funds from other banks for the short term is called reverse repo rate.

How it’s done: Here the apex bank sells government bonds to banks with a promise to buy back the bonds from the banks in the future. Whenever banks are flushed with short-term funds, reverse repo allows banks to deposit these funds with RBI and also earn interest on the funds. Until 24 January, the reverse repo rate was 5.25%, after Tuesday’s hike of 25 bps, RBI will now borrow funds from banks at 5.5%.

What Happens

Whenever RBI wants to reduce liquidity in the banking system, it increases the rates. This leads to reduction in liquidity, which results in an upward movement in interest rates.

RBI also increases these rates to curb inflation. When inflation goes up, RBI hikes interest rates to make money more expensive. When funds become expensive for banks, they are forced to hike their interest rate on loans and fixed deposits. Though this time the hike is just 25 bps in both repo and reverse repo rates, money will still become more expensive for banks. Hence there is a possibility that banks may hike interest rates for customers.