The Reserve Bank of India (RBI) hiked the repo rate on May 4, 2022 by 40 basis points to 4.4% from the earlier 4% with immediate effect. This decision, which brings an end to the low interest regime, was taken unanimously by the Monetary Policy Committee (MPC).

The RBI said the decisions is aimed at achieving the medium-term target for consumer price index (CPI) inflation of 4% while supporting growth. RBI Governor Shaktikanta Das said, "As several storms hit together, our actions today are important steps to steady the ship."

While the move is to bring down inflation so there's no "collateral risk" and strengthen the economy's growth prospects, a common Indian citizen is still unsure as to what repo rate is and how it impacts them. FactChecker asked economists to simplify this term and how the domino effect of this increase will affect an Indian citizen.

What is Repo Rate?

The RBI defines repo rate as "a money market instrument, which enables collateralised short-term borrowing and lending through sale/purchase operations in debt instruments". A more simplified description would be the rate at which banks get loans from the RBI.

"If banks need to borrow from the central bank, then they have to pay an interest rate on that and that is the repo rate," explained Sabyasachi Kar, RBI Chair Professor, Institute of Economic Growth.

People know of the financial system as banks giving loans to individuals, who then deposit money in the banks. "To carry out their activies, banks need liquidity in the form of reserves. When banks have too much liquidity, they deposit this with the RBI to earn interest on it, which is reverse repo rate. When they don't have enough, they borrow from the RBI and pay interest on it, which is the repo rate," added Kar.

This liquidity is provided "against the collateral of government and other approved securities under its Liquidity Adjustment Facility", said Vivek Kumar, economist at QuantEco Research. After a day, the commercial banks are required to buy back their deposited securities with the central bank, Kumar added.

Why Did the RBI Hike Repo Rate?

The MPC cut the policy repo rate by 115 basis points (bps) right after the pandemic broke out during March-May 2020, on top of a cumulative reduction of 135 bps during February 2019 to February 2020. "The RBI's move to reduce repo rate at the beginning of the pandemic significantly was to give a monetary policy support to the economy. The economic activities are dependent on loans and, in a pandemic, paying high interest on loans becomes difficult because activity is disrupted," said Kar.

He described that if interest on the loan would have remained high, it could have led to many more businesses going bankrupt. "Now that we are slowly getting out of the pandemic while we still have strong inflationary tendencies owing to the global scenario (Russia-Ukraine war and COVID wave in China), the central bank believes we need to work towards a tight monetary policy to bring down inflation," added Kar.

Here are the factors listed by the RBI behind their decision:

  • In March 2022, CPI inflation rose to 7% from February's 6.1%, largely reflecting the impact of geopolitical spillovers.
  • Food inflation increased by 154 basis points to 7.5% and core inflation rose by 54 bps to 6.4%
  • The World Trade Organization scaled down projection of world trade growth for 2022 by 1.7 percentage points to 3%.
  • The International Monetary Fund (IMF) revised down its forecast of global output growth for 2022 by 0.8 percentage point to 3.6% in less than three months.
  • While overall system liquidity remained in large surplus, India's foreign exchange reserves declined.

Apart from controlling inflation, ratings agency CRISIL in its report on the hike also attributed it to the risk to financial stability. "The sudden hike in policy rates seem to have been spurred by a sharp rise in inflation, and growing risks to financial stability from US Federal Reserve's monetary policy tightening," read the report.

Subhada Rao, economist and founder of QuantEco Research, told FactChecker that this hike is one among the many steps taken by the RBI to moderate economic activity. "The RBI hiked repo rate as the CPI inflation is expected to exceed the policy tolerance threshold of 6% in 2022-23. The hike in the benchmark interest rate in the economy is one among the many steps taken by the RBI to control inflation, as it increases the cost of liquidity, while ensuring some moderation in the pace of economic activity," said Rao.

How it Impacts an Indian Citizen?

The RBI uses repo rate as the main lever to carry out the monetary policy or the benchmark tool for sending out monetary policy signal. "The central bank can change this rate if it wants and use it to make credit cheaper or expensive. Since banks depend on this liquidity for creating credit in the economy, the whole interest structure gets affected," said Professor Kar.

This means changes made to the repo rate impact a broad spectrum of interest rates, on both borrowing and lending side. "For example, when RBI hikes repo rate, it increases the overnight cost of borrowing for commercial banks. This incentivises commercial banks to attract more funds from depositors at a higher rate, thereby resulting in an increase in deposit rates for bank account holders," explained Yuvika Singhal, economist at QuantEco Research.

This means that if the repo rate goes up, theoretically, the whole interest rate structure in the economy is supposed to increase. This will have a differential effect. So, the lenders will be better off because they will get more interest, and borrowers worse off as interest rate burden will increase. Kar gave an example saying that pensioners, whose major income is the interest they earn from deposits will go up.

"The only flip side to this hike is that it might also dampen, to a small extent, the growth prospects as low interest rates do encourage growth in many ways. So, some people at the margin may suffer and this may limit the government's ability to borrow and carry out some of the welfare activities," explained Kar.

This highlights how the short-term effects of the move may be difficult to manage, but the mid-term effects may provide stability to the economy. "In the short term, as banks pass on the rise in repo rate, the EMIs are going to get costlier for the common man. At the same time, with increase in deposit rates, the depositors can expect some additional interest income. Over the medium term, as inflation starts to moderate, the common man would benefit from better purchasing power," concluded Singhal.

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