The Reserve Bank of India (RBI) on Wednesday announced its latest monetary policy decision, raising the repo rate by 25 basis points to 5.5% from 5.25%. The central bank also changed its policy stance from ‘neutral’ to ‘calibrated tightening’.
The repo rate is one of the RBI’s key monetary policy tools and influences borrowing and liquidity conditions in the financial system. But what exactly is the repo rate, how does it work, and what does an RBI rate hike mean for ordinary borrowers and consumers?
Also read: RBI raises repo rate by 25 points in first hike in four years, loan EMIs may rise
What is repo rate?
Repo is the short form of repurchase agreement. It is a short-term, collateralised borrowing arrangement in which one party sells securities to another and agrees to buy them back at a predetermined date and price.
The repo rate is the annualised interest rate charged on the funds transferred from the lender to the borrower.
In simple terms, it is the rate at which the RBI lends money to commercial banks. In return, commercial banks sell government securities to RBI with an agreement of repurchase at a predetermined price and time.
A repo has two parts: the initial sale of securities and their repurchase at a later date. The difference between the two prices reflects the cost of borrowing, or the repo interest.
Also read: RBI Repo Rate Hike: What does a 25 basis point increase mean for your home loan EMI?
Who fixes the repo rate?
The repo rate cannot be calculated using a simple formula. The rate is determined based on the prevailing economic and money-market conditions.
The RBI is responsible for the repo rate. The Monetary Policy Committee of RBI decides repo rate after carefully examining the market conditions such as, inflation, economic condition and the value of currency. The committee also conducts a meeting in every two months to examine the market conditions.
When deciding the repo rate, the RBI looks at factors such as inflation, liquidity in the financial system, borrowing conditions and other money-market rates. It then decides whether to raise, reduce or keep the rate unchanged.
Henceforth, repo rate can be effectively used for controlling, inflation and liquidity of the economy.
What instruments are used in a repo?
A repo transaction requires securities to serve as collateral. The RBI text lists government dated securities, Treasury Bills, corporate bonds, money-market securities and equity among instruments that can be used for transactions.
Repos can also take different forms, including buy-sell back repos, classic repos, bond lending and borrowing, and tripartite repos. They may be overnight, for a fixed term, open-ended or flexible depending on the arrangement.
Why does the RBI use repos?
Repos are important because they allow maintenance of economic needs. The RBI can use repo transactions as part of open-market operations to influence liquidity and reduce short-term volatility in money-market rates.
What does repo rate mean for you?
For an ordinary person, the repo rate is not a loan rate that you directly pay to the RBI. Its importance is indirect.
When the RBI changes the repo rate, it changes conditions in the short-term money market. This can influence the cost at which financial institutions acquire funds and, in turn, affect borrowing and investment conditions.
In simple terms when the repo rate increase your interest rates can also increase.