In context with the Indian banking terminology, Repo Rate is known as the repurchase agreement. This repurchase agreement exists between the custodian central bank of India RBI and commercial banks of India. The commercial banks use its government bonds and securities as collateral backed by a borrowing instrument, and the interest charged on this transaction is called the RBI Repo Rate. In the dearth of adequate funds, commercial banks sell the collaterals with an agreement to repurchase them at a later time with a pre-determined price.
Reverse Repo Rate as the name propounds is completely contrasting to the repo rate. This means when commercial banks want to deposit their excess capitals with the central bank RBI, these are offered an interest rate, which is called reverse repo rate. In other words, it is interest levied on the money borrowed by the RBI from the commercial banks of India.
Comparing the impact of Repo Rate and Reverse Repo Rate
Regulating liquidity: In context to the structure of liquidity, the RBI gives provision to commercial banks of India to manage the requirements of fund deficiency or liquidity needs. The repurchase agreement promotes and ensures that there is no liquidity emergency in the country through this particular framework. Similarly, when there is a surplus flow of cash or money in the economy, the RBI, as a custodian, control the damage through reverse repo agreement. The surplus flow gets absorbed through this rate of interest.
Inflation regulation: RBI takes the prime responsibility of using these effective monetary tools in bringing out a balance between mechanisms of inflation and deflation in the economy. Too much liquidity brings about inflation in the economy, while lesser liquidity makes the market sluggish, and both situations can bring adverse effects on the financial health of the country. This money flow can be controlled by bringing alterations in the repo rate and reverse repo rate.
Alteration in Repo Rate and Reverse Repo Rate by RBI
Repo Rate alteration: Alternating the repo rate can bring vital changes in the financial sector and market scenario of the country. With an elevation in the repo rate, the liquidity is imbibed back in the system, making interest rates on loans and credit costlier to the people than before. This means that now, lesser loans will be sanctioned by limiting the money supply, which in turn influences the growth of the economy. On the contrary to this, a cut down on the repo rate by RBI means the cashflow is induced in the system, which means loans will be available at cheaper rates, and chances of approval also become high. Though it depends upon a bank whether they will implement these new interest rates on their loans or not.
Reverse Repo Rate alteration: To curb the excessive liquidity factor, RBI may escalate the interest rates so that commercial banks in India gets attracted to invest more money with the central bank. Though the surplus flow will be reduced, this provides a risk-free option for the banks to park their funds. But when RBI decides to reduce the reverse repo rate, the liquidity factor in the economy increases with commercial banks seeking more lucrative and possibly less speculative investment schemes. Based on these criteria, the interest rates on loans for customers are managed by the banks.
A glance on the difference between Repo Rate and Reverse Repo Rate:
- The repo rate is always higher in comparison with the reverse repo rate in the Indian banking scenario.
- The mechanism of functioning in repo rate is that commercial banks borrow money from RBI using collaterals like securities and bonds, while in reverse repo rate, the banks deposit their excess funds with RBI.
- Both the monetary tools are used by RBI to bring changes in the economy. The repo rate is meant to control inflation; on the other hand, the reverse repo rate controls the supply of money.
- The objective of the repo rate is to meet the scarcity of money, and the reverse repo rate aims to safeguard the liquidity factor in the economy.
Also Read:- RBI Monetary Policy
These two monetary tools are essential in maintaining and controlling the financial sector of our country, and RBI, as a custodian bank, knows how and when these tools can be used.