What is Repo Rate – Meaning, Definition, and Importance

The repo rate, short for the repurchase rate, is a key monetary policy tool used by central banks to influence and control the money supply and interest rates within an economy. It plays a crucial role in determining the overall cost of borrowing money and, consequently, affects economic activity. The article discusses the concept of repo rate. Learn about its components, importance, and the formula to calculate the repo rate.

Repo Rate Definition: The Repo rate is the repurchasing option or interest rate at which banks borrow money from the central bank. In India, the Reserve Bank of India (RBI) is the central bank and uses it to regulate inflation. 

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“Repo” is a shortened form of "Repurchasing Option" and denotes the repurchase of securities by the government that previously sold them. The repo system helps governments control the money supply within economies by increasing or decreasing the available funds. Central banks set these rates.

Content

• How Does Repo Rate Work?
• How to Calculate the Repo Rate?
• Repo Period
• Components of a Repo Rate Transaction
• What Is Reverse Repo Rate?
• Current RBI Bank Interest Rates
• Importance of Repo

In the event of inflation, RBI increases the repo rate, decreasing it during deflation. The RBI increases the rate to reduce the liquidity in the economy, thereby arresting inflation.

Repo and reverse repo are part of the liquidity adjustment facility within an economy.

How Does Repo Rate Work?

Repo stands for ‘repurchase option’ or ‘repurchase agreement.’ It is a short-term borrowing that enables commercial banks to borrow money from the central bank against government securities. It plays a crucial role in monetary policy. This process also requires both parties to agree about repurchasing those securities after a specified period and cost higher than the initial selling price. 

A repurchase agreement allows banks to raise short-term capital more quickly and securely. 

The repo transaction comprises two phases –

Phase 1 – Transaction for a nearer date – In this phase, the selling of the security and its repurchasing take place. The sale price is based on the available market price for outright deals.

Phase 2 – Transaction for a future date – The price is determined based on the fund’s flow of interest and tax elements of funds exchanged.

In terms of the transaction, both phases are booked as spot sale/purchase transactions. Thus, after adjusting for accrued coupon interest, sale and repurchase prices are fixed to yield the required repo rate.

How to Calculate the Repo Rate?

The banks need to secure a standard repo rate. The interest rates paid by the commercial banks to the RBI or the interest rates they get when they deposit money in the RBI must be agreed upon and standardized.

The repo rate formula is as follows – 

Repo Rate = (Repurchase Price – Original Selling Price ÷ Original Selling Price) x (360 ÷ n)

Where:

• Repurchase Cost = Original Selling Price + Interest
• Original Selling Cost = Sales Cost of Security
• n = Number of Days to Maturity

Repo Period

There is no restriction on the maximum period for repos. It could be an overnight term, open or flexible, or it can be one week. Overnight repos last just one day. 

It is a term repo if it has a fixed period and an advanced agreement. In such case, either party may call termination of the repo at any time. However, it requires prior notice of 1 -2 days.

There is no such fixed maturity period in an open repo. The interest rate would change daily depending on the money market conditions. In such cases, the lender agrees to provide money indefinitely, and the agreement can be terminated any day. Under flexible repos, the lender places funds, but the borrower withdraws them as per his requirements over an agreed period.

Components of a Repo Rate Transaction

Central banks will not just lend money to other banks whenever they demand it. To secure loans from the central banks, certain factors need to be in place, which include – 

1. Inflation – With the repo rate, the central banks keep inflation at its limit. Central banks can increase or decrease the rate according to inflation at a given period.

2. Hedging and Leveraging – The primary goal of the RBI is to hedge and leverage. They buy securities bonds from commercial banks and provide them with cash in exchange for deposited securities.

3. Short-Term Borrowing – The repo agreements are for a short period, and the RBI has clearly stated it. Commercial banks must buy back their securities at agreed-upon prices and periods.

4. Collateral and Security Components – The RBI accepts collaterals as bonds or gold in exchange for the loaned money.

5. Cash Reserve – Commercial banks borrow money from the central bank to maintain their cash reserve or liquidity as a preventive action.

Current RBI Bank Interest Rates*

Repo rate – 6.5%

Reverse repo rate – 3.35%

*As of Dec 13, 2023.

Importance of Repo Rate

• Safer investment since security acts as collateral in this type of agreement.
• Maintains liquidity in the market
• Checks inflation in the economy
• Lower interest rate as compared to an unsecured loan

A reduced repo means the availability of loans at cheaper interest rates. Lower interest rates are likely to reduce commodity prices, ultimately benefitting the end consumer.

Conclusion

Repo rate plays a crucial role in monetary policy and the functioning of the financial system. Understanding the repo rate helps individuals, businesses, and policymakers make informed decisions about borrowing, investments, and monetary policy implications. It contributes to maintaining stability and equilibrium in the financial markets while supporting the broader economic objectives of a country.

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