Before getting into the details, let us first understand -

What is Repo Rate?

Definition of Repo Rate: Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which commercial banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.

What is Reverse Repo Rate?

Definition of Reverse Repo Rate: It is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RBI since their money are in safe hands with a good interest. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to this attractive interest rates. It can cause the money to be drawn out of the banking system.

In order to tame inflation, anchoring inflationary expectations and considering the signs of strong economic revival  RBI on March 19 , 2010 announced Monetary Policy Measures  with immediate effects:

  • to raise the repo rate under the liquidity adjustment facility (LAF) by 25 basis points from 4.75 % to 5 %
  • to raise the reverse repo rate under the LAF by 25 basis points from 3.25% to 3.5%

This is the second action since January when RBI announced a 75-basis point rise in the cash reserve ratio (CRR) to 5.75 per cent. But, unlike CRR, which is used to manage liquidity in the system, an increase in the repo and reserve repo rates is aimed at signaling an increase in interest rates.

The action by RBI is the first increase in policy rates since July 2008 when the repo rate was increased 50 basis points. The reverse repo was last raised in July 2006, when RBI raised the rate 25 basis points. Since October, 2008, RBI started the process to reduce interest rates and lowered the CRR to inject liquidity in the system to spur economic activity in the wake of the global downturn. These steps of RBI comes against the backdrop of rising inflation which touched 9.89 per cent in February YoY basis which has exceeded the base line projection of 8.5% for end march 2010 set out in the third quarter review and RBI for the first time said that wholesale price index-based inflation may cross double digits in March 2010.

As per RBI as liquidity in the banking system will remain adequate, credit expansion for sustaining the recovery will not be affected and the RBI will continue to monitor macroeconomic conditions, particularly the price situation, and take further action as warranted.

Impact:
The overall interest rate of banks on advances (like housing loans, consumer loans, auto loans etc) will go up. It is not expected to have a major impact on corporate borrowings in the immediate future. Yield on government securities, which eased to 7.82 per cent, from a 17-month high of 8.02 per cent last week, could harden in the days ahead.

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Author: Abhijeet Ahir, Economic Analyst, MBA Finance (SIIB)

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