Repo & Reverse Repo Rates

The Reserve bank of India (RBI) governor, Dr. Raghu Ram Rajan in his mid term credit policy on October 29^th 2013 raised the repo & the reverse repo rates by 25 basis points (bps). Thus the existing repo rates & reverse repo rates are 7.75% & 6.75% respectively. The CRR (Cash-Reverse Ratio) was left unchanged at 4%.

Since the last two & a half years RBI has consistently increased the Repo & Reverse repo rates from 4.5% to the current 7.75%. The RBI is of the view that by increasing these rates, the scourge of inflation can be countered. Let’s see the logic of these increases.

Repo –rates are the rates at which RBI which is the central bank of India lends its money to commercial banks. Reverse-repo rate is the rate at which commercial banks park their money at RBI. The Repo-rate is always higher than the reverse repo rate. I.e. by logic, the RBI lends at the higher rate than it borrows. This is the basic rule in any business to make money. Thus it also gives an answer as to why lending rates are more than the deposit rates.

The RBI is of the opinion that the hike in repo rate, like the one on 29th October 2013, helps controlling the inflation. Hiking the repo-rate means the central bank i.e., the RBI will lend money to the commercial banks at higher rates. The commercial banks in turn will in turn lend the money at the higher rate to the corporate & individual investors. The home loan, car loan EMIs will be a more costly affair & the demand will reduce. Thus inflation will be tapped.

But there is another side to this logic. If the corporate entities & business houses are getting loans at a higher rate, this would directly lead to an increase in their cost of production & their working capital. Thus they would be forced to increase the prices of their products. Thus people would buy less & ultimately if people are buying less, the GDP (gross domestic product) of the country is reduced, which is not good for any economy.

Thus there has to be a clear cut balance between growth & inflation. Hiking the repo & reverse repo rates would tame inflation, but growth will be driven down. The current scenario is a double whammy. About, two & a half years back India’s GDP was above 8%, which is currently at sub 5% levels. We have sacrificed 8% growth levels by hiking the rates, but the inflation does not seem to come down.

The RBI governor will now have to tread very cautiously maintaining a balance between growth & inflation, & not to say use these rates (repo & reverse repo) to the country’s advantage.