Difference Between Repo Rate And Reverse Repo Rate

Two critical components of Indian monetary policy are repo rate and reverse repo rate. These rates are set by the Reserve Bank of India (RBI) and significantly influence the cost and availability of credit in the economy. As an SME, these rates affect your business loan interest rate and impact overall economic factors such as liquidity and inflation. This article will explore the difference between these rates and how they impact the economy and your business.

How would you define Repo Rate?

Repo rate, or repurchase rate, is a tool the RBI uses to control money supply and price stability in the economy. When commercial banks need short-term funding, they can access loans from the RBI at this rate. Commercial banks use government securities as collateral when borrowing from the RBI.

The Monetary Policy Committee (MPC) regularly reviews economic conditions and decides on the appropriate rate. If the central bank wants to control rising prices, it increases this rate. This, in turn, leads to higher borrowing costs for SMEs. If the RBI plans for economic growth, it lowers the rate, making it cheaper for banks to borrow and leading to more affordable MSME loans.

How would you define Reverse Repo Rate?

Commercial banks lend money to the RBI at an interest rate known as reverse repo rate. This rate is lower than repo rate.

When the central bank wants to reduce funds in the market, it increases this rate. This encourages banks to park more funds with the RBI, leaving them with reduced funds for lending. Conversely, when the RBI aims to increase market funds, it lowers this rate, making it less attractive for banks to keep their funds with the central bank.

Comparing Repo vs Reverse Repo Rates

	Repo Rate	Reverse Repo Rate
Direction of fund flow	In a repo transaction, funds flow from the RBI to commercial banks.	In a reverse repo transaction, funds flow from commercial banks to the RBI
Impact on liquidity	When this rate decreases, more money becomes available within the banking system.	Lowering this rate makes it less attractive for banks to store extra funds centrally, thereby increasing available liquidity in financial markets.
Effect on interest rate	This serves as a benchmark for borrowing costs in the financial system.	Changes in reverse repo rate lead to higher rates if banks prefer to earn risk-free returns from the RBI

How These Rates Affect the Country

Influence on economic growth

Banks can access funds at a lower rate when the RBI cuts repo rate. As a consequence, interest rates across various financial products such as business loan, MSME loans, term loans, and line of credit tend to decrease. Businesses find it easier to access capital, which can fuel economic growth. On the other hand, an increase in these rate by the RBI can curb inflation by elevating borrowing costs and decreasing the circulation of money in the financial system

Effects on the strength of currency value

These rate changes affect the value of the Indian Rupee. When the RBI increases these rates, it leads to a stronger Rupee as higher interest rates attract foreign investments. This can be beneficial for businesses importing raw materials but challenging for exporters.

Conversely, when the RBI lowers these rates, it leads to a depreciation of the Rupee. While this may benefit exporters, it increases the cost of imports and contributes to inflation. For SMEs seeking business loan or collateral free business loan, currency fluctuations can impact their ability to repay if they have foreign currency exposure.

Effects on stock markets and investments

The stock market is highly sensitive to changes in these rates. When the RBI lowers these rates, it leads to increased stock market activity as investors seek higher returns in equities compared to fixed-income investments. This creates a favorable environment for businesses to raise capital through equity markets.

However, when the RBI raises these rates, it can lead to a temporary downturn in the stock market as fixed-income investments become more attractive. This shift can affect the overall investments and impact the business loan eligibility of SMEs looking to expand or invest in new projects.

Implications for Small and Medium Enterprises (SMEs)

Effect on working capital and cash flow management

Cost of working capital: Repo rate changes impact the cost of working capital for SMEs. When repo rate drops, you face smaller interest burdens on your operational loans. Higher interest rates mean higher EMIs on existing loans.

Liquidity management: Banks tend to allocate additional funds to the RBI when reverse repo rates are higher. This results in reduced liquidity available for lending to SMEs.

Short-term borrowing: Small businesses often rely on short-term borrowing (like overdraft) for managing cash flow fluctuations. The difference between these rates influences the rates on these short-term loans. This affects your ability to manage seasonal cash flow variations effectively.

Opportunities and challenges presented by rate fluctuations

Expansion opportunities: During periods of low repo rates, you find it more feasible to take on business loan for expansion, equipment purchases, or entering new markets. 

Demand for products/services: When interest rates rise, overall consumer spending tends to decrease as people save more and borrow less. This can reduce demand for SMEs’ products or services.

Competitiveness: Businesses with higher debt become less competitive when rates rise because their business loan EMIs increase relative to less debt competitors. Lower rates level the playing field, especially for newer or more indebted SMEs.

Tips for SMEs to Stay Informed About Rate Changes

Reliable sources of information

• The RBI’s site provides the most accurate information on policy decisions.
• Reputable business news websites provide in-depth analysis of RBI monetary policy and its impact on business loan and the financial system.
• Your business loan provider or bank can offer insights on how rate changes might affect your MSME loans, term loans, or line of credit. FlexiLoans offers term loan upto ₹1 crore with various flexibility in terms of payment schedule, interest rates, and collateral requirements

Key indicators to watch

Inflation: The RBI often adjusts rates to control inflation. Higher inflation may lead to an increase in repo rate to reduce liquidity in the market.

GDP growth: Slow economic growth leads to lowering repo rate to stimulate borrowing and investment.

Liquidity conditions: When the banking system has surplus cash, the RBI may raise reverse repo rate to attract more deposits.

Global economic trends: International economic conditions also influence domestic policy decisions.

Fiscal policy announcements: Government spending and taxation policies impact the RBI monetary policy decision.

How to interpret RBI announcements

Monetary Policy Committee (MPC) meetings: The RBI conducts bi-monthly MPC meetings to review and set rates. Pay attention to these dates and the subsequent announcements.

Policy stance: Look for keywords like ‘accommodative’, ‘neutral’, or ‘hawkish’ in the RBI’s statement. ‘Accommodative’ means the RBI wants to lower interest rates or maintain low rates to support economic growth. ‘Neutral’ suggests that the central bank sees the existing rates as appropriate for the economic conditions. And ‘hawkish’ means the RBI is concerned about inflation and it might raise interest rates.

Forward guidance: The RBI often provides hints about future policy moves. Look for statements about economic outlook and potential future actions.

Learn How Rbi Repo Rate Hikes Will Impact Your Loan EMI?

Conclusion

Repo rate and reverse repo rate are important policy tools to influence – liquidity, inflation, and the overall financial health of the economy. For SMEs, understanding these rates is essential as they not only impact the cost and availability of credit but also affect your business expansion opportunities. This knowledge allows you to time your borrowing and manage your existing loans.

These rates are one aspect of the complex economic environment in which your business operates. You should always look at them along with other factors like – market demand, competition, and your specific business needs when making financial decisions.

FAQs

Q1. Who decides repo rate?

Ans: The RBI decides this rate.

Q2. Why repo rate is called repurchase rate?

Ans: In a repo agreement, one party sells securities to another party with a commitment to repurchase them at a later date.

Q3. How Does monetary policy control inflation?

• The RBI can raise key policy rates to make borrowing more expensive. This reduces money supply and spending, helping to curb inflation.
• By increasing the (Cash Reserve Ratio) CRR, the RBI can reduce the amount of money banks have available to lend, tightening the money supply.
• The RBI can sell government securities to remove excess liquidity from the market.

Q4. Why monetary policy is important?

• Proper policy helps maintain stability in the banking and financial sectors.
• These policy measures can impact the value of the rupee, affecting trade and foreign investment.
• By influencing interest rates and money supply, these policies help stimulate or cool down economic activity as needed

Q5. In what ways are monetary and fiscal policies distinct from each other?

	Monetary Policy	Fiscal Policy
Definition	The process by which the Reserve Bank of India (RBI) controls the supply of money in the economy	The government’s use of taxes and spending to shape the economy.
Authority	Reserve Bank of India (RBI)	Ministry of Finance
Objective	Price stability, economic growth, exchange rate stability	Economic growth, employment generation, income redistribution
Instrument	Repo rateReverse repo rateCash Reserve RatioStatutory Liquidity RatioOpen Market Operations	Government expenditureTaxationSubsidiesPublic debt management