REPO RATE HIKE – Fundamentals

IN ITS war against inflation, Reserve Bank of India (RBI) has used its another tool, the policy rates of repo (the rate at which RBI lends to banks). With immediate effect, the RBI has hiked repo rate by 25 basis points to eight per cent from 7.75 per cent under Liquidity Adjustment Facility (LAF). Repo rate is the rate at which our banks borrow rupees from RBI

The last repo rate hike by 25 basis points was on March 31, 2008, when war against inflation (6.46 per cent at that time) forced RBI to hike the policy rates. The reverse repo rate is at which Banks Park short term funds to RBI is maintained at six per cent. So there is a huge gap of 200 basis points (ie two per cent) between repo rate (eight per cent) and reverse repo rate (six per cent).

What does this 25 basis point hike in repo rate mean to commercial banks?

1. RBI charges two per cent extra interest to banks when it lends to banks compare to banks (who gets two per cent less) what they earn when they park their funds with RBI. So spread between RBI and commercial banks is in favour of RBI by 200 basis points.

2. For commercial banks taking short term finances from RBI will be costlier by 25 basis points. Cost of funds to banks will increase correspondingly.

3. By increasing the gap between repo and reverse repo rate, RBI is indicating the commercial banks to make the lending in the market less attractive.

4. Net Interest Margin pressure will mount on banks as they have to pay more to RBI, while managing their asset liability of banking business.

5. To maintain its net interest margin, banks will be forced to hike their prime lending rates and consequently all other interest rates on its advances and loans.

What does this 25 basis point hike in repo rate mean to public?

1. Immediate repercussions will be hike in the interest rate on various loans and advances of the banks. This means you have to pay more if you have taken loan from the banks.

2. Your housing loan EMI is going to be hiked with immediate effect as burden of 25 basis points and additional interest to RBI is certainly going to be passed on to the consumers. This hike may be somewhere in the range of 0.5-1.00 per cent.

3. Increase in Public Lending Right (PLR) means banks will increase the interest on the loan what it gives to its customers. While the similar hike in the deposit rates what banks pays to its customer may not necessarily be there. This means that what you pay to banks will increase but what you get from the banks will remain the same.

4. If banks decides to hike its PLR (which they are certainly going to do), the effect of hike in interest rate would be on all existing loan accounts and any fresh loan accounts. So if you are planning to take fresh housing loan it will be dearer and if you already have taken loan your repayment of loan will be costlier.

By hiking the repo rate under its Liquidity Adjustment Facility, RBI is trying to control liquidity in market as increased repo rate will make the credit availability more costly. Increased repo rate will force slowdown in credit off take from commercial banks. Slow off take of credit means less funds will be available in the market for purchases and businesses etc and ultimately, the money supply in the market will be restricted. Low level of money supply helps government and RBI to tackle inflation as inflation means lot of money chasing to a few goods. Now RBI wants that a few of money to chase a whole lot of goods (which government tries to ensure by removing supply restrictions in the market) so that prices of goods will cool down which have a cozy effect on mounting inflation touching as high as 8.24 per cent. To what extent does RBI's measure to tame the inflation would help remains to be seen in the coming weeks only.