When you borrow money from the bank, the transaction attracts interest on the principal amount i.e. cost of credit. Similarly, banks also borrow money from RBI during a cash crunch on which they are required to pay interest to the Central Bank i.e. repo rate.
The term ‘Repo’ stands for ‘Repurchase agreement’ – the rate at which RBI lends money to all the commercial banks in the country in the event of scarcity of funds. In other words, it is the rate at which Commercial Banks sell their securities and bonds to RBI with an agreement to repurchase the securities and bonds from RBI on a future date at a per-determined price.
It is a powerful arm of the Indian monetary policy that can regulate the country’s money supply, inflation levels, and liquidity. Additionally, the levels of repo have a direct relationship with the cost of borrowing for banks. Higher the repo rate, higher will be the cost of borrowing for banks and vice-versa.
Repo rate is one of the main tools used by RBI to control inflation. During high levels of inflation, RBI makes strong attempts to bring down the flow of money in the economy. One way to do this is to increase the repo rate. This makes borrowing a costly affair for businesses and industries, which in turn slows down investment and money supply in the economy. As a result, it negatively impacts the growth of the economy and helps bring down inflation.
On the other hand, when the RBI needs to pump funds into the system, it lowers the repo rate. Consequently, businesses and industries find it cheaper to borrow money for different investment purposes. It also increases the overall supply of money in the economy. This ultimately boosts the growth rate of the economy.
Lending rates and deposits offered by banks are impacted by a rise or fall of repo rate. The Repo Rate can cause a range of effects on the overall economy whether it is an impact on the banking sector, an impact on the average citizen or some other aspect of the Indian economy. Here is you guide to take you through various scenarios –
Impact on the Banking System
Banking is the first sector to get affected by any change in monetary policies.
- Increase in Repo Rate:
Rise in the lending rate leads to a slowdown for the banking sector which impacts their profitability. Banks also in turn raise the rate of bank deposit offered to customers to attract more inflow of funds in the system.
That means higher equated monthly installment for existing borrowers and higher rate of credit for new borrowers. Home loans and other floating rate loans get majorly affected due to rate change.
- Reduction in Repo Rate:
It’s a big relief to bank when Reserve Bank of India decides to reduce the repo rate. With the dip in repo rate, banks can borrow from Reserve Bank of India at a cheaper rate. With the accessibility of low cost credit, banks may even reduce the lending rates to its customers after analyzing the liquidity condition and the deposit inflows. Banks may offer credit to its end customer at a reduced rate.
As bank loans get cheaper, consumers can spend and borrow more while spending a lot less in borrowing. Increased lending business will boost the profitability of the overall banking system. However, lending rate cut and deposit rate hikes are purely dependent on the bank’s liquidity position and deposit demand from customers.
Impact on the Common Man
- Increase in Repo rate:
When RBI decides to hike the repo rate; it becomes costlier for commercial banks to borrow short term funds from RBI. Increased repo rate discourages the bank from availing short-term loans and advances from RBI. Due to non-availability of low cost funds, banks hike the lending rate for its customers to pass on its high interest burden.
That means loan becomes costlier for a common man. This may automatically reduce consumer purchasing power. On the other hand, banks may begin to offer fixed deposits at an increased rate to attract more inflow of funds. It basically helps consumer to save more with increased rate on bank deposits.
- Reduction in Repo rate:
When Reserve Bank of India decides to reduce the repo rate, loans and advances become cheaper for the commercial banks as they can avail short-term credit from Reserve Bank of India at the reduced rate.
Rate cut may push banks to reduce their prime lending rate. Reduction in prime lending rate encourages more borrowers by making credit accessible at lower rates to the common man. With the increased opportunity to borrow, consumers can spend more and avail loans to achieve future financial goals easily.
Impact on the Economy
- Increase in Repo Rate:
When RBI hikes repo rates, it becomes costlier for banks to borrow thus they attract more interest on their short-term borrowings from the RBI. Costlier credit option for banks prompts them to hike the lending rate which they offer to their end customers. Expensive loans discourage the borrowers to avail the credit facility which cuts down excess cash to reduce money supply in the market thereby stabilizing liquidity in the market taking away the customers purchasing power. Consumption, expansion and production also take a downfall with the lesser money supply hindering our GDP growth which in-turn hits every sector creating a domino effect.
As the lending get expensive, borrower gets discouraged and demand for bank loan reduces. It reduces the money supply in the economic system and thereby reduces the rate of inflation.
- Reduction in Repo Rate :
Repo rate cut boosts the economic activities and prompts healthy growth with adequate supply of money in the market. It not only helps grow monetary funds by is beneficial for economic growth. When RBI decides to cut the repo rate, the short-term loans for commercial banks become cheaper. This prompts them to offer consumer loans at a relatively cheaper rate. This increases the consumption as people will have more money at their disposal which positively impacts the country’s GDP growth.
Cheaper availability of credit encourages businesses to grow & expand and motivates foreign players to invest in Indian financial market. Prices of products get lower with the availability of low cost capital. New investments lead to better employment opportunities in the economy.
Every action in the economy has a positive and a negative effect. The implication of one in the right time period determines how much an economy can cope and grow in their current environment. This happens to be one of the main reasons why RBI revises repo rate on a regular basis to keep the inflation rate under control and also to strike a balance between both – economic growth and rising inflation.