There was news earlier this month that the RBI increased the repo rate by 25 basis points to 6.25 percent and the reverse repo rate to 6 percent from the earlier 5.75 percent. This was the first increase in repo rates since January 2014 and the first under the Narendra Modi government.

Some media reports declared that this increase officially marked the turning of the interest rate cycle even though banks have been raising rates on deposits and loans for a few months now. Interest rates started going down from 2015 and the last rate cut was in August 2017.

This decision was taken by the MPC, or Monetary Policy Committee headed by Urjit Patel, governor of the Reserve Bank of India. It received wide coverage across mainstream media, going beyond traditional financial news media. Let’s try to examine what is so important about repo rates that it made such big news.

The terms “Repo Rate” and “Reverse Repo Rate” are frequently used in the financial sector. When you read news like “RBI raises key interest rate”, they are referring to repo and reverse repo rates. Repo rate is the rate at which the Reserve Bank lends money to commercial banks when there is a shortage of funds.

A ‘repo’ is, technically, a repurchasing option. For instance, person A gives person B a signed piece of paper in exchange for Rs100. The paper states that A will repurchase the signed piece of paper from B at a given date in the future for Rs 110. The 10 rupees is the ‘Repo Rate’, in this instance 10 percent. In the case of repo agreements between the Reserve bank and regular commercial banks, the interest rate has been hiked to 6.25 percent.

Reverse repo rate is the rate at which the RBI borrows money from commercial banks. This has now been pushed up to 6 percent. Changes in the repo rate affect bond yields and influence borrowing costs and loan rates.

You might have heard that the central bank tweaks the repo rates and reverse repo rates to control inflation. That’s true. We’ll get to that in a bit. But first, let’s examine how repo rates work and what purpose they actually serve in the financial system in India. And how they affect you and me.

When a commercial bank in India goes through a financial crisis, it approaches the Reserve Bank to borrow money or funds. In layman’s terms, your bank has your money in the form of deposits. It lends this cash out as loans, but sometimes it need a bit of help when it falls short. That means the amount of loans it is handing out is more than the money it has in its vault. Or whatever other way it keeps its hoard of cash.

The interest at which the bank borrows these necessary funds from RBI, by selling securities and bonds, is called Repo Rate. In simple words, Repo is the rate at which the central bank of India lends funds to commercial banks when those banks face a financial crunch and are unable to take care of their expenses. In such cases, repurchasing agreements are signed by both parties stating that the securities will be re-purchased on a given date at a predetermined price. Similar to the 10 percent interest rate example I shared earlier.

Repo rates in India are fixed and monitored by the Reserve Bank of India. Repo has its origin in Liquidity Adjustment Facility, or LAF. The LAF which was launched by the RBI in 2000 with two aims - to inject liquidity into the banking system when required, and to absorb liquidity from the banking system should the need arise. It proves beneficial for handling short-term financial crises.

Repo rate is used to also control money supply and inflation levels in the country. If the economy needs reduced money supply, the RBI increases the repo rate, making it difficult for banks to borrow funds. Likewise, to pump more money into the system, the central bank may reduce the repo rate, encouraging banks to borrow more.

Technically, a repo is a contract in which banks provide eligible securities such as Treasury Bills to the RBI while availing overnight loans with a commitment to buy them back at a set price. Repos are generally undertaken on overnight basis, i.e., for a one day period. Banks can borrow from the RBI through the repo window by submitting eligible securities as collateral while getting an overnight loan at the same time paying an interest rate called repo rate.

The consideration amount in the borrowing phase of the repo transactions is the amount borrowed by the seller of the security. On this, interest at the agreed ‘repo rate’ is calculated and paid along with the consideration amount of the second leg of the transaction when the borrower buys back the security. Settlement of repo transactions happens along with the outright trades in government securities.

All such transactions are reported on the electronic platform called the Negotiated Dealing System or NDS. The Clearing Corporation of India Ltd., the CCIL, has put in an anonymous online repo dealing system in India, thus moving telephonic over-the-counter trading to an anonymous order matching electronic platform. The duration between the two parts of a repo transaction – from when the RBI buys the securities to when these securities are bought back – is called the repo period.

The sale price of securities sold by commercial banks is usually based on the prevailing market price for outright deals. When the ownership of securities passes from seller, i.e. the banks, to buyer, i.e. the RBI, for the repo period, legally the interest accrued for the period has to be passed on to the buyer. Therefore, in the second leg happening on a future date, the price will be structured based on the funds flow of interest and tax elements of funds exchanged.

Reverse repo is the flipside of such a contract. Commercial banks, the ones you and I bank with, can park excess cash with the RBI using a rate of interest known as Reverse Repo rate. In such a scenario, when banks have excess money, they can offer it as a loan to the RBI. However, the Reserve Bank does not give any securities, like Treasury Bills, to these banks in return for the cash.

To simplify it, the three parts of a reverse repo transaction are go something like this -

1 - Your bank parks its excess cash with the RBI for one day.

2 – This parked money will be considered a one-day loan by the bank to the RBI.

3 – The RBI pays an interest rate called reverse repo rate to the bank.

Now, understandably, of the two, Repo is the more important one. When the repo is changed (i.e. hiked or reduced by the RBI), it inevitably has an impact on the reverse repo rate.

Now that we have a fair understanding of what the repo rate is, let’s look at how it works in the financial system.

Before the launch of repo in the year 2000, the most important monetary policy instrument used to counter inflation was the CRR, or cash reserve ratio. This is the amount of money that banks have to deposit with the RBI. If the central bank increases the CRR, the cash available with the banks goes down. The RBI uses CRR to pull excessive money from the financial system. The current CRR rate is 4%. If the Reserve Bank cuts CRR, it could led to gain in the lending and investing power of banks. For example, if a bank deposits Rs.100 and the CRR is 10% per annum, the liquid cash that the bank should have at all times, as mandated by the CRR, is Rs.10. The remaining 90 rupees can be used for lending and investment purposes.

After a few years of its introduction, repo emerged as the most effective instrument to fight inflation. sidelining even CRR. With the introduction of inflation targeting, RBI has made repo its ‘policy rate’. This means that it is the only policy instrument used to fight or target inflation and ensure price stability.

A couple of points to note here about repo rate and inflation –

According to the new inflation targeting monetary policy framework, there is only one objective-price stability, one target- inflation and one instrument – repo rate.

Two, over time, borrowings through the repo route have gone up. Banks borrow heavily to meet their liquidity requirements. In response, the central bank has introduced newer arrangements like variable rate repo, marginal standing facility etc. to inject money into the banking system.

So when borrowing through the repo route, the repo rate becomes crucial, enhancing its ability to influence interest rates in the banking system. Such trends have helped strengthen repo rate as a monetary policy instrument.

One important factor that made repo more influential, if I may, is the reliance on repo loans by the banks when borrowing from the Reserve Bank. The role of LAF, or Liquidity Adjustment Facility, as a supplier of ready liquidity has expanded as repo borrowings by banks increased. Commercial banks are using repo more frequently and in more volumes compared to call money. Wait, another term that needs a definition.

Call money rate is the rate at which short-term funds are borrowed and loaned out in the money market.

So, to reiterate, commercial banks are using repo more frequently and in more volumes compared to call money. When the dependence on LAF repo for commercial banks to get liquidity increases, the underlying interest rate of repo rate becomes binding for commercial banks. Hence, when the repo rate is increased by the RBI, banks are tempted to increase their individual lending and deposit rates as well.

Therefore, repo rate is the interest rate anchor in the short-term, and is frequently used by the RBI to counter inflation. Whenever the RBI changes the repo rate, banks are forced to change their interest rate to reflect that. The higher the repo rate, the higher is the cost of borrowing for banks. And vice-versa. When an economy has high inflation, attempts are made to reduce the money supply in the system.

To achieve this reduction in hard cash floating around the country, the central bank increases the repo rate. This makes it expensive for businesses, and indeed all industries, to borrow money. This, in turn, slows down investment and reduces the supply of money in the economy. However, even as such a measure brings down inflation, it also slows down the growth of the economy.

Conversely, when the RBI needs to pump funds into the system, it lowers the repo rate. This makes it easier for the businesses, and industry, to borrow money for investment purposes. It also increases the overall supply of money in the economy. This ultimately boosts the growth rate of the economy.

Reverse repo rate has an inverse relationship with the money supply in the economy. During high levels of inflation in the economy, the RBI increases the reverse repo rate which encourages banks to park more funds with the RBI and earn higher returns on idle cash. In this way, excess money is drained from the banking system. Banks have less cash to extend as loans and this curbs the purchasing power of individuals.

As you’ve figured out by now, the central bank tweaks these rates when necessary to control inflation and maintain a healthy amount of cash in the country. Which brings us to the recent hike. The RBI increased the repo rate by 25 basis points to 6.25 percent and the reverse repo rate to 6 percent.

The Economic Times noted that the rate hike signals the start of a rate tightening cycle after a multi-year period of benign interest rates that benefited borrowers. Analysts say the RBI is being cautious. Arvind Chari, Head of Fixed Income and Alternatives at Quantum Advisors, told ET, “The RBI has hiked the repo rate but retained its stance at neutral which suggests that it wants the flexibility and be data dependent. It also conveys that we may not be in a long rate hiking cycle and the rate hikes are more pre-emptive against emerging inflation risks.”

Inflation has increased and economic growth in India has recovered in recent months, which has led to an increase in the interest rates. The central bank projected inflation for the FY19 at 4.8 to 4.9 percent in the first half and 4.7 percent in the second half of the financial year. The monetary policy committee retained its growth forecast of 7.4 percent for the economy. GDP, it said, is likely to grow at 7.5 percent to 7.6 percent in the first half and 7.3 percent to 7.4 percent in the second half of the financial year. The monetary policy intends to keep inflation in check by adjusting the interest rates. There are reports that there could be a review of the rates in August and even a change towards the end of the year, should the need arise.

How does this impact banks, and consequently, us? Sometimes, bigger loans like, say home loans, could be impacted due to a change in the reverse repo rates. If the RBI cuts the repo rate, it doesn’t necessarily mean home loan EMIs would get lesser or the interest rates come down. The lending bank also needs to reduce its ‘Base Lending’ rate for the EMIs to decrease. Home loan rates or fixed rate consumer loans aren’t impacted by RBI’s rate cut. The rate of interest is fixed with respect to fixed loans.

The immediate fallout - interest rates could begin to firm up. Banks have been raising lending as well as deposit rates over the recent months. Analysts say some banks have raised MCLR, or marginal cost of funds-based lending rate. Essentially, the cost of borrowing will go up. The Economic Times observed that, for existing borrowers, the EMI burden will increase as banks started hiking rates. However, this increase of EMI will be felt by the consumer when the reset date of the loan arrives. On the reset date, future EMIs will be calculated based on the MCLR, or marginal cost-based lending rates, effective on that date.

Banks are likely to also increase deposit rates which is good for savers. Most banks as well as markets had factored in the rate hike already. Dharmakirti Joshi, chief economist at Crisil, says, “Even without the RBI move, there was a de-facto rate hike in the system in G-Secs, corporate bonds, bank MCLR and deposit rates, all of these were anyway rising.” And, as mentioned earlier, observers expect more rate hikes. CPI inflation (other than food and fuel) and food inflation could increase from 4.7 percent to 5.7 percent and 2.2 percent to 3.1 percent in FY19.

Sameer Narang, chief economist with the Bank of Baroda, told Mint he expects the RBI to raise rates by another 0.25% in the next six months as inflation is likely to remain above the central bank’s target of 4%. Narang added, “Further policy action will depend on movement of oil prices, rupee and government’s MSP policy.”

Some analysts say this rate hike will slow down India’s growth trajectory. Food and oil prices are out of the government’s control. Food inflation depends largely on a good monsoon. Oil prices are determined by international market scenarios and oil-producing countries. An anticipated rise in crude oil prices given geopolitical incidents, and in prices of primary commodities due to a spurt in consumption expenditure, led the RBI to hike the rate to contain prices. An increase in minimum support prices for agricultural products may also put pressure on the price level. And since we import 80% of our oil, one of the major inputs for economic activities, this impacts price levels across the board, including consumer goods.

The repo rate hike could affect important sectors like construction and automobiles as banks will pass on the hike by increasing interest rate on loans. Several banks have already increased their lending rates by 10 basis points, say analysts. Pravakar Sahoo, Associate Professor with the Institute of Economic Growth, University of Delhi, says the credit off take, which started rising in last couple of quarters and crucial for the growth, may moderate again. Private investment, which saw a revival in recent quarters after a slow down in recent years, could find it untenable to absorb the rate hike, he says. The professor hopes inflation is moderated around 4 per cent and there is no further hike by end of the year due to the monsoon, oil prices, increase in market support price, etc. Else, it could well dampen investment, economic activity and squeeze the fiscal space for the government.