The Reserve bank of India (RBI) uses repo and reverse-repo rate to control the money supply in India under the liquidity adjustment facility (LAF).
Not only the Reserve Bank of India, almost all central banks use it as a key tool to manage money supply and inflation. The Federal Reserve also enters into a repurchase agreement to regulate money supply in the US.
What is a liquidity adjustment facility (LAF)?
Liquidity adjustment facility is a tool used by RBI to manage liquidity and basic stability in the financial market.
Liquidity adjustment facility allows banks in India to borrow money through repurchase agreement (repo) and to make loans to the Reserve Bank of India (RBI) through reverse repo agreement.
What is the repo rate?
Repo stands for “Re-purchasing option” or “repurchasing agreement”.
Banks in India are using repurchase agreements under liquidity adjustment facility (LAF) to resolve their short-term cash shortages in case of economic instability or fund shortage.
In repurchase agreement, banks use eligible securities as collateral to get funds from RBI to reduce their short term fund requirements. This facility is implemented on a day to day basis to ensure enough capital is available in the market.
Which means, Repo rate is the rate of interest that is paid by the commercial bank to the Reserve Bank Of India when the RBI lends money to the commercial bank.
For example, suppose XYZ bank has a short term cash shortage due to bad economic conditions. They have the option of using RBI’s liquidity adjustment facility. By executing a repurchase agreement (repo), the XYZ bank can sell government securities to the Reserve Bank of India (RBI) in return for a loan with agreement to repurchase those government securities.
When a commercial bank like HDFC, AXIS, ICICI, SBI, BOB, UBI, BOI, Kotak and Federal Bank are in a shortage of funds, they borrow money from the Reserve Bank Of India (RBI) against securities such as treasury bills and government bonds.
What is the reverse repo rate?
The bank which requires capital uses repurchase agreement (repo) to fulfill their short term fund requirements, while banks having excess capital use reverse repo rate to fund RBI.
Suppose a bank has excess cash on hand. They can use reverse repo agreement by making a loan to the Reserve Bank of India (RBI) in exchange of government securities.
Reverse repo rate is used by the Reserve Bank of India (RBI) to regulate the flow of money in the market.
Impact of high and low repo rate
Increase in repo rate increases the cost of short term funding. This reduces the money supply to the economy as the general public will not be interested to borrow money with higher interest rates.
Conversely when the repo rate is lowered, money supply to the economy increases due to low cost of funding as a result businesses are encouraged to grow.
At the time of high inflation, the Reserve Bank Of India (RBI) increases the repo rate to reduce the money supply in the economy. Due to higher repo rate banks are discouraged to borrow money from RBI.
When inflation falls, the repo rate is reduced to increase money supply to support economic growth.
A change in repo rate affects public borrowing in the same proportion as cost of funding increases or decreases based on RBI’s decision.
Reverse repo rate will always be lower than the repo rate.
Increase in reverse repo rate will encourage banks to deposit money with RBI for higher return. This will help RBI to absorb excess funds from the market to reduce money supply, in turn money available for borrowing by the general public will be reduced. Along with the repo rate, the reverse repo rate is used as a tool to manage inflation.
When the repo rate is reduced, interest relates to home loan, EMIs also reduces.
