Why does RBI review the Repo Rate? Know how a small change of 0.25% changes your EMI, inflation and the entire market mathematics.

Monetary policy is the most effective weapon with the Reserve Bank of India (RBI) for the smooth operation of the Indian economy and to maintain financial stability. Its central point is ‘Repo Rate’. Repo rate is the standard interest rate at which the central bank of the country provides short-term loans to commercial banks (like SBI, HDFC Bank, PNB) for their immediate needs. The 6-member Monetary Policy Committee (MPC) constituted under the RBI Act meets every two months to closely assess the pace of inflation (inflation rate) and economic growth (GDP Growth) in the country. The primary statutory obligation of the central bank is to keep the retail inflation rate (CPI) limited at 4% (with a fluctuation margin of 2%, i.e. in the range of 2% to 6%). Whenever the price balance in the economy deteriorates or there is an imbalance of liquidity in the market, then RBI reviews the repo rate and gives a balanced direction to the market.

The decision taken by RBI on repo rate completely depends on the liquidity of money present in the market. When the prices of essential commodities, raw materials and services start rising rapidly in the market and inflation threatens to cross the prescribed limit, the central bank increases the repo rate to absorb excess cash from the market. As the rates increase, it becomes expensive for the banks to borrow from the Reserve Bank, due to which the banks also increase the interest rates on loans for their customers. As loans become expensive, people start postponing home, car or other personal expenses and the industry slows down new capital expansion (Capex). As a result, the aggregate demand in the market decreases and inflation gets put on hold. On the contrary, when there is an economic recession or sluggishness in the country, the RBI cuts the repo rate to accelerate growth, which makes loans cheaper, increases investment in the market and creates new employment opportunities.

Often the general public thinks that a change of 0.25% or 25 basis points is very small, but in long-term financial contracts this mathematics can make a difference of lakhs of rupees. As per the orders of RBI from October 2019, floating retail loans of all banks are directly linked to the external benchmark (EBLR) i.e. repo rate. This can be easily understood with a practical example.

If banks extend the loan tenure by not increasing the EMI amount, then the 20 year loan increases to approximately 21.5 years, due to which the borrower has to pay additional installments for one and a half years.

The change in repo rate not only affects the borrowers, but it also decides the equation of returns on fixed deposits and savings accounts of the bank. When the central bank increases the repo rate, banks have to pay higher costs to raise funds. To meet their credit growth demand, banks immediately increase FD interest rates to attract common citizens and especially senior citizens. For example, when the repo rate increases, the interest rates on FDs of 1 to 3 years go up to 7.5% to 8.25%, thereby increasing the fixed monthly income of retirees and risk-averse conservative investors. On the contrary, when the repo rate decreases, banks are the first to cut deposit rates, thereby shrinking the returns on safe investments.

Changes in the repo rate also have a deep impact on the country’s stock market (Sensex and Nifty) and the exchange rate of the Indian rupee. If the RBI makes an unexpected increase in rates, the increase in borrowing costs of companies puts pressure on their net profit margins, leading to selling pressure in the stock market. Stocks of real estate, automobile and banking sectors are considered most sensitive to the repo rate. On the other hand, when interest rates remain competitive, foreign portfolio investors (FPIs) are attracted to the Indian bond market, thereby strengthening the Indian rupee against the US dollar. In this way, every bi-monthly review of repo rate is not just a technical process, but it is the most important wheel that controls the entire macroeconomic structure, from the household budget of every citizen of the country.