Repo rate is one of the components of the monetary policy of the Central banks (i.e., Reserve Bank of India in India) which is used to regulate the money supply, liquidity in the country and to control the level of inflation. Repo rate is an interest rate at which commercial banks borrow money from the Central banks in case of shortage of funds. This loan amount is sanctioned to banks overnight or in a day. The loan is provided against the collateral of eligible government securities under the liquidity adjustment facility (LAF).
Repo rate is used in controlling inflation. For example, In the event of inflation, central banks increase the repo rate by basis points which makes costly for businesses and industry to borrow money. This, in turn, slows down investment and reduces the supply of money in the economy. As a result, this helps bring down inflation. however, this move also has a negative impact on the growth of an economy.
The announcement of repo rates significantly impacts the stock market as well. It is considered very important information by traders and investors. A higher-than-expected interest rate hike is bad for markets.
In India, the transaction of funds (loan amount sanctioned) backed by approved securities has two legs:
- In the first leg, the bank sells the required value of approved securities to RBI. RBI will release funds to the bank against this transaction.
- In the second leg, the bank buys back the same securities. The price for buying them back (higher than the price for the first leg) is pre-decided when the repo transaction is agreed upon.
The difference between the prices for the two legs thus is the borrowing cost for the borrowing bank. A reverse repo is the opposite of a repo.