Decrypting Repo Rates and its impact

Sandip Bhandare analyses the concept of Repo Rate and its impact on economy

The recent box office success of the movie ‘RRR’ has made the initials a household name. Recently, the Reserve Bank of India (RBI) also contributed to trending these initials by hiking the Repo Rate (RR)/Reverse Repo Rate (RRR) within a space of just 35 days. This has had a huge impact on the stock markets and has caused a lot of flutter in the business community. Let us understand the What, When, Why, and How much in detail:

The What: Repo stands for ‘repurchase option’ or ‘repurchase agreement’. It is a form of short term borrowing that allows banks or financial institutions to borrow money from other banks or financial institutions. The money is borrowed against government securities with an agreement to buy those securities back after a specified time period and at a predetermined price (which is higher than the initial sell price). The duration of these loans generally vary from one day to a fortnight.
The Repo rate is the rate at which the central bank (RBI) lends money to commercial banks in the event of any shortfall of funds. Similarly, the Reverse Repo rate is the rate the RBI pays its commercial banks to park their excess funds with RBI.

The When: When there is a shortage of funds, the banks borrow money from the central bank which is repaid according to the repo rate applicable. When in need, the central bank of a country borrows money from commercial banks and pays them interest as per the reverse repo rate applicable. At a given point in time, the reverse repo rate provided by RBI is generally lower than the repo rate.

The Why: A repo is a secured way of raising short-term capital for banks. While repo rate is used to regulate liquidity in the economy, the reverse repo rate is used to control cash flow in the market.
In the event of inflation, the RBI needs to control prices and restrict borrowings. Therefore, RBI increases the repo rate to de-incentivise banks to borrow, and encourage banks to make deposits and earn returns. This in turn absorbs excessive funds from the market and reduces the money available for the public to borrow. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.

The RBI takes the contrary position in the event of a fall in inflationary pressures. When there is a need to infuse more money into the market and support economic growth, the Repo rate is decreased to reduce the cost of funds.

The How Much?
As can be seen, the Repo rate till 6th February 2020 was 5.40%. When covid struck, the economy and the sentiment was badly affected RBI decreased the repo rate first to 5.15%, then to 4.40% and finally to 4% making plenty of liquidity available with the economy. The excess liquidity and the easy money policy together with other factors may have spurred demand but have also increased inflation. With the rising inflation the RBI became very concerned and the first increase of 40 basis points was carried out after a gap of almost two years. The second increase has been made just after a month or so with the increase of 50 basis points.

Impact on Capital Markets: The capital market and the repo rates have an inverse relationship. Every time the central bank increases the repo rate, its immediate impact is seen on the capital markets.
The hike in the repo rate prompts companies to cut back on the spending on the expansion, which leads to a dip in growth and affects the profit and future cash flows, resulting in a fall in stock prices. If several companies follow suit, it eventually leads to a fall in markets. It is noticed that capital intensive sectors have been more vulnerable to these changes than other sectors such as Information Technology (IT) or fast-moving consumer goods (FMCG).

Impact on Businesses: Even a small hike in repo rate makes borrowing from the commercial banks expensive. Home loan, vehicle loan, education loan, personal loan, business loan, credit cards, mortgages are all influenced by the rate hike.
For home buyers, this hike signals an imminent end to the all-time low-interest regime. Low interest has been one of the major drivers behind home sales across the country since the pandemic began. The rise in interest rates will ultimately impact overall acquisition cost for home buyers and may dampen residential sales to some extent.
When the borrowing cost increases, the common man is discouraged from making unnecessary purchases, thereby reducing the demand for goods and services. This kicks off a chain reaction, leading to a reduction in prices and thereby, the inflation. When borrowing business loans becomes expensive, businesses either reduce or freeze hiring, leading to unemployment.
If the economy stalls, the government will have a reduced capacity to spend on infrastructure building and other welfare projects. If the government borrows too heavily to compensate for all this, international agencies may give the country bad ratings.

Repo Rates vs. Inflation: Recently, the RBI raised its inflation projection for the current fiscal year to 6.7 per cent, up from 5.7 per cent predicted in April 2022 and 4.5 per cent in February 2022. The latest forecast is well above the RBI’s target range of 2-6 per cent. In actual terms, inflation was found to have surged to an eight-year high of 7.79 per cent in April 2022.
The war is a significant factor. High crude oil prices not only mean costlier petrol, diesel, CNG and cooking gas, but transportation of essential commodities also costs more.
Then we have a weakening of the Rupee against the US Dollar, whose demand has been high. As a result of global uncertainties, the Rupee has been falling due to foreign investors pulling out money from the stock and bond markets. A weakened Rupee has a reduced purchasing power.
Inflation depletes our forex reserves because we are spending more dollars on crude oil, reducing our ability to import other goods that we need. As we are an import-oriented country, this leads to fewer and costlier foreign goods, and a further weakening of the Rupee.

The RBI’s Dilemma: Consumers are further losing purchasing power at a faster-than-usual rate due to the soaring inflation. The RBI cannot adopt aggressive monetary tightening like other advanced economies because the economy is not completely out of the woods yet. While there are signs of mild revival in investment cycle, private consumption is yet to move strongly above pre-pandemic level. External risks from the ongoing geopolitical tensions and high commodity prices continue to threaten growth, forcing RBI to continue with its accommodative policy.
A rate hike will definitely impact consumer demand for houses, consumer durables and other discretionary items. With credit to the large companies and industries just beginning to revive, the rate hike could slow down credit growth to industry, too.
But over the longer-term, price stability will play an important role in supporting demand. It is expected that RBI will not be that aggressive toward the end of the year because growth will begin to slow then and it is very conscious about the sacrifice ratio (growth versus inflation).
If the inflation rate continues to increase despite the recent changes in repo rate, RBI will resort to hiking it again in a few months to keep inflation in check.

To Conclude: Just like an entertainment show series, each successful episode is followed by a cliff-hanger at the end with a new ‘R’ villain, be it the Rising inflation, the Russia Impact, the Rupee devaluation and the recurrence of covid. We trust that the RBI will rise to the challenges as always


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