Reserve bank of India (RBI) plays a major role in regulating the flow of money in the country. It does so by managing the interest rate at which money is lent by major financial institutions, especially banks. When banks need to lend money to entities (companies, individuals, government organizations etc), they often borrow money from the RBI to do so. When RBI lends money to banks in this way, they do so at an interest rate. This interest rate is called the ‘repo rate’.

When banks lend out money, they naturally charge an interest rate that is higher than the rate at which they borrowed the money from RBI. This ‘lending rate’ is a few percentage points higher than the repo rate (at which they borrowed from RBI). When the repo rate goes down, banks borrow money at a lower rate and lend money at a (relatively) lower rate as well. When this happens, companies, individuals, and other institutions have access to money at a lower rate. And that stimulated economic growth in the country.

The ‘reverse repo rate’, as the name suggests, is the opposite of the repo rate. This is the rate at which RBI takes money from the banks. That is, this is the rate that RBI would pay to banks for their ‘deposits’. 

If you think of RBI in this manner – essentially as a lending institution – you can see that the reverse repo rate will always be slightly lower than the repo rate. That is, RBI will always pay less interest rate for its deposits than what they charge for the money they give out to the banks.

In essence, repo rate is the money that RBI charges the banks for lending money to them, and reverse repo rate is the money that RBI pays to the banks for holding their money.

The current repo rate is 4.00% and the reverse repo rate is 3.35%. RBI announces these rates usually once every two months. However, there could be changes in the interim as well. The announcement comes in the form of a monetary policy document. Here is a sample document from recent past.

Apart from repo rate and reverse repo rates, there are also a couple of other important rates using which RBI regulates how banks function. Prominent among them are the Cash reserve ratio (CRR) and the Statutory Liquidity ratio (SLR).

As we saw above, RBI manages the flow of money in the economy, and essentially the growth rate of the economy by changing these rates. How does that work? While it is a very complex topic, broadly speaking, when these interest rates are ‘low’, there is more money in the economy and with easy access to money, companies can grow their businesses. 

However, when such growth happens, an undesirable side effect also happens. And that is inflation. As there is more and more money in the economy, the value of this money goes down and the cost of goods goes up, causing inflation. 

A moderate amount of inflation is good for the economy, but if it gets too high, it will affect the people’s spending power, especially that of the poor and the middle class. Hence, RBI would like to keep that in check.

They do so by, when it is the right time, increasing the rates. When the repo rate increases, banks would have to raise their lending rates as well. And that means companies have a harder time raising money and their rate of growth slows. And, theoretically, this would lower the rate of inflation, as there is a lesser amount of money in circulation in this condition.

Broadly speaking, this is how RBI ‘regulates’ the pace of growth of the economy. In an ideal situation, RBI’s rate management will ensure that there is a steady, controlled growth of the economy with moderate inflation.

As the central bank, RBI has to take various factors into consideration while deciding on the direction of the monetary policy in general, and the interest rates in particular. Some of these factors are:

• Demand and supply of money in the economy
• Inflation rate at the wholesale and consumer levels
• Government borrowing and spending plans
• Broad influencers of the economy such as monsoon, pandemic etc
• Global monetary policies, interest rates, and liquidity

RBI takes all these factors into account while determining what level of interest rates would be appropriate for the current situation. Also, RBI tries to avoid making the rate too volatile with frequent ups and downs – they try to do so by making it directional – either up or down over a period of few quarters or years.

Banks benchmark their interest rates – both on the savings/deposits they receive from customers and the loans they give out – on the interest rates set by RBI. So, when RBI lowers the interest rates, banks are likely, over a period of time, to follow suit. While there will always be a gap between the RBI rate and the rate offered by the bank, they tend to move in the same direction. 

However, it should be noted that banks are not under any obligation to follow the RBI rate movement. That is, if RBI cuts the interest rate by 0.5%, it does not automatically mean the bank will cut the interest rate on the loans it offers by the same amount. This process, called the ‘transmission of rate’ happens at the discretion of the banks and at a time they choose.

As of this writing (in mid 2021) the repo rate is at an all time low at 4%. It is unlikely that the rate will go further down. The recent trend (as can be seen from the chart above) has been downward (to tackle the economic impact of Covid), and it looks like it will remain this way until the economy recovers fully. After that RBI will likely start tackling inflation by gradually raising the rates.

During this period, banks have turned risk-averse in terms of their lending. That is, they are not lending money to risky businesses which could give them a higher rate of interest, and which in turn could result in an increase in FD rates. So, although banks have an ability to borrow money from RBI, their ability to pay out higher deposit rates depend on their willingness and ability to lend money at rates even higher. As banks turn cautious, their deposit rates cannot go higher.

The current interest rate scenario is one of low rates. However, as the country emerges from the pandemic, this could change, and RBI would turn their attention to taming inflation, and will cause a rise in interest rates. Hence, one could say that we are at an inflection point in terms of interest rates in India.

As RBI stated in its recent policy statement, the central bank has “decided to continue with the accommodative stance as long as necessary to sustain growth on a durable basis and continue to mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward”. Hence, we can see that the regulator is concerned about curbing the flow of money in the country at the time of recovery from the pandemic.

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