A well thought of and well planned monetary policy is as important for a country as oxygen is for life because it is by monetary policy, supply of money is controlled by the monetary authority of a country, generally central bank to ensure economic stability and to achieve high economic growth. In other words, monetary policy is a process by the monetary authority of a country controls the supply of money by having its control over the interest rates in order to maintain price stability and attain economic growth. The Reserve Bank of India is the central monetary authority designated and authorized to make monetary policy and thus its primary objectives are:
And in order to achieve its objectives, RBI uses various instruments such as open market operations; cash reserve ratio; statutory liquidity ratio; bank rate policy; credit ceiling; credit authorization scheme; moral suasion; repo rate and reserve repo rate.
What is Repo Rate?
Repo rate is the rate at which the central bank or the monetary authority of the country i.e. The Reserve Bank of India lends money to other banks in case there is a shortfall of funds/cash. Repo, a short form of Repurchase involves the sale of a security with an agreement to repurchase the same security back at a higher price at a later date and repos are generally a very short-term and its duration ranges from overnight to 30 days or more. The reason why repo rate is called or known as repurchase rate is because other banks borrow money from the RBI, they have to keep government securities as collateral and once they repay the money to the RBI, they collect the collateral. Short-term maturity and government backing provides the lender, i.e. the RBI with minimal or extremely low risk and thus makes it one of the most trusted monetary instrument used by the RBI.
Like when we need money, we borrow it from the banks in form of loans such as home loan, car loan etc and pay certain interest on the same, which is otherwise known as cost of credit i.e. the rate at which we borrow the money. In the similar manner, when banks are in shortage of liquid cash or funds, they approach the central monetary authority i.e. the RBI and borrow money in lieu of government securities.
One of the main reasons why repos are used by the RBI is to control the inflation and in case of inflation where the prices of goods increase, RBI increases the repo rate as a disincentive so that commercial banks cannot borrow money from it which ultimately cuts the circulation of money in the market and thus helps in arresting the inflation; and in case of deflation, where the prices of goods go down, the central bank i.e. the RBI lowers the repo rate making it easier for the commercial banks to borrow money from the RBI and hence circulation of money in the market increases and thus helps in curing deflation. Thus, RBI controls the rate of interest in the economy by controlling these rates and takes contrary position in the event of fall and rise in inflationary pressures. Higher the repo rate, higher is the cost of short-term money and vice-versa.
For example: If a commercial bank has taken loan of 1000 Rs from the RBI and repo rate is 5%, then they will pay interest of Rs 50 to RBI.
A higher repo rate may have an adverse impact on the economy and may slowdown its growth and a lower repo rate; banks charge low interest rates on the loans and thus encourage people to apply for loan. However, this might not be the case always and in real time, the lending rates or the interest rate on the loan reduces only when the banks reduce their base rate, which is the minimum rate below which they are not authorized to give loans and even if there is a cut in the repo rate by the RBI, there might not be any change in your monthly installments because since the bank has not reduced its base rate, the effect of repo rate cut has not reached you.
The Reserve Bank of India decides every fortnight whether to change or maintain status quo on its repo rate because tweaking the same has its effect on millions and thus RBI takes its call on repo rate prudently after considering vital factors such as:
- Current trend on inflation - RBI studies the path or the trajectory of the inflation before reaching on any conclusion related to repo rate.
- Fiscal projections - It is important and crucial for the RBI to study and predict the future inflationary pressure in order to decide a repo rate so that the economy can be controlled.
- Fiscal deficit - Fiscal deficit is the rate which is promised by the Union Government in their budget plan and one of the important factors which RBI considers before deciding repo rate.
And as per the preamble in the RBI Act, amended by the Finance Act 2016, the utmost primary objective of RBI is to maintain price stability while keeping in mind the objective of growth and thus the onus to decide repo rate is on the Monetary Policy Committee (MPC) which is a five member team comprising of both RBI officials and external experts. The external experts are nominated and appointed by the Appointments Committee of the Cabinet and serve for four years and once retired, they are not eligible for re-appointment. Proposed by Patel, then a deputy governor of RBI in the year 2014, the MPC strives and ensure they meet the inflation target as decided by the RBI and government. The UK and US also follows the same pattern as RBI and has representative from both the central bank and the government who decides on the repo rate. The main reason behind having monetary policy committee framework was to replace the previous system where the RBI governor and his team had complete control over monetary policies. However, the RBI is under no obligation or pressure to accept the recommendations of the external experts. It was in the month of July 2015 when there was a recommendation to change the structure of the existing MPC and to increase the external members and make it 4 and after couple of discussion, the finance ministry and RBI agreed on a six member MPC.
Usually repo rate is considered to be same as bank rate because both are used by the commercial and central banks, however both the rates i.e. bank rate and repo rate have some prominent differences. Both bank rate and repo rates are used to regulate the supply of money or currency in the economy.
Some of the basic differences between the two can be summed up as below:
Like repo rate, reverse repo rate is another important financial instrument used by the RBI in order to maintain economic stability and promote growth. Reverse repo rate, as the name indicates is the reverse of repo rate and in this case, it is the rate at which RBI borrows money from the commercial banks or the rate of interest which commercial banks get when they keep their surplus money with the RBI and is always higher than the repo rate.
”At present, the reverse repo rate is 6.25% whereas the repo rate is 6.5%.”