REPO rate reduction of 0.25% is making the Indian investors excited. Investors believe this will trigger higher off-take of loans, higher economic activities. In reality, cheap money only can’t trigger more demand or higher capacity built up. There are several other factors.
However, in this post, we will know about the RBI’s interest rate management. RBI manages liquidity in the market and inflation with REPO and reverse REPO rate management.
REPO means Repurchasing Option.
What is REPO rate?
When the banks are facing a shortfall of money the RBI lends money to the banks at X% of interest. This X is the REPO rate.
What is reverse REPO rate?
This is the rate RBI pays to the banks when banks deposit excess money with RBI.
This way RBI controls the liquidity in the system. Lowering the REPO rate indicate a lower interest rate. When RBI wants to add more liquidity in the market, the REPO rate is lowered.
They can do it even by decreasing the Reverse REPO rate. When RBI pays less interest on the money to the banks, banks would like to lend the money in the market rather than depositing with RBI. This way RBI encourages higher liquidity in the market.
They assume a lower rate will increase the off-take of loans. This is possible if banks pass on the lower rate benefits to the borrowers.
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More money in the system triggers inflation. When the increase in demand does not result in more supply, prices go up. This leads to inflation. Inflation leads to high price economy. The purchasing power of the rupee comes down. People feel the pinch of high price and as a result purchasing power of the consumers comes down.
When the inflation is high, RBI manages it with the money supply. They can reduce the money supply by a higher reverse REPO rate. This curtails lending activities by the bank and money is squeezed from the system.
When there is a slump in the economic activities, REPO rate is reduced and lending becomes cheaper, reserve REPO rate is reduced to boost liquidity.
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Impact on Consumers:
The cheaper rate of interest means consumers will avail loans to buy consumer goods and homes, they will borrow for their personal use. This boosts demand and economic activities.
When banks lower rate of interest on existing loans, this also helps existing borrowers in lower EMIs.
But when the REPO rate is increased, the cost of borrowing goes up. This high-cost money reduces the overall demand for money. The consumers borrowing reduces.
When the reverse repo rate is increased, banks park excess money with RBI rather than lending to the borrowers. This way the liquidly is withdrawn from the system. Consumers will find it difficult to borrow. Those who can borrow will borrow at a higher rate.
Impact on Business:
Lower REPO rate is good for the manufacturer/service providers as overall demand in the economy goes up. This also helps the manufacturer/service providers enhance the production capacity to cater to an increase in demand. They can think to expand the capacity when the borrowing cost is low.
This can also lower their borrowing cost on existing loans. This is good for profitability.
Higher REPO rate increases the cost of borrowing and higher reverse REPO rate reduces the liquidity and makes borrowing more stringent.
Inflation, liquidity, high, and low demand, all are business critical data. RBI’s action on interest rate influence all these.
So, RBI’s action on REPO and resevrse REPO rate certainly impact the business.
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Impact on the Economy:
“Interest rates are used to achieve overall economic stability.” Ben Bernanke
Subject to all the other factors, the impact on the Economy of tinkering of interest rate is as expected by the RBI.
It can boost demand, it can reduce inflation, it can suck liquidity or it can increase liquidity in the system.
|Increase in REPO rate||Cost of borrowing goes up, calm downs economic activities|
|Decrease in REPO rate||Cost of borrowing goes down, boosts economic activities|
|Increase in Reverse REPO rate||Suck liquidly from the market, reduces inflation|
|Decrease in Reverse REPO rate||Boost liquidity in the market boosts demand, helps in economic expansion, could trigger inflation|
The banks also get the benefit of REPO rate reduction as more borrowing increase their income. It’s a win-win for all.
But the banks also have to do a balancing act. When they reduce the interest rate on loans, they also have to reduce interest on deposits. (Bank’s profit is mainly the difference between the deposit rate and the lending rate) earns by the depositors. Three is a risk of deposits going from banks to higher interest rate instruments.
Both REPO and Reverse REPO rates are used by RBI to manage money liquidity in the system, generate demand, and also in managing inflation. It’s a balancing act. RBI has to remain watchful to intervene at the right time.
RBI’s decision to increase or decrease the rates indicates the state of the economy and how RBI wants to influence the state of the economy.
REPO and reverse REPO rates play an important role in managing the economy.
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“Low-interest rates are a big opportunity for investment. But the issue is that this money should go to the real economy, not the financial economy.” Carlos Slim
Money going to the real economy is increases the GDP. Money going to merely in investing activities (financial economy) is not healthy for the economy. It increases financial and investing activities without a corresponding increase in the GDP.
This is in brief what you need to know about REPO/ Reverse REPO rates and the resultant impact on the interest rate and the economy.
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