Repo rates and housing

The Reserve Bank of India has done it again. In the recently announced credit policy in January' 06, it has again increased the repo rate as well as the reverse repo rate.
In the Credit Policy review done in January' 06, the RBI has hiked the repo rate - the rate at which RBI lends to banks - from 6.25 percent to 6.50 percent. Repo rate is used to repo rate, used to add funds to the market. It has also hiked the reverse repo rate - a short-term benchmark rate in the money market - by 25 basis points, from 5.25 percent to 5.50 percent.
What are these rates and how do they impact the interest on housing loans?
Repo is a money market instrument , which enables collateralised short term borrowing and lending through sale/purchase operations in debt instruments. Under a repo transaction, a holder of securities sells them to an investor with an agreement to repurchase at a predetermined date and rate.
In the case of a repo, the forward clean price of the bonds is set in advance at a level, which is different from the spot clean price by adjusting the difference between repo interest and coupon earned on the security.
The terms of the transaction are structured to compensate for the funds lent and the cost of the transaction is the repo rate. The inflow of cash from the transaction can be used to meet temporary liquidity requirement in the short-term money market at comparable cost.
Repo rate is nothing but the annualised interest rate for the funds transferred by the lender to the borrower. Generally, the rate at which it is possible to borrow through a repo is lower than the same offered on unsecured interbank loan for the reason that it is a collateralised transaction and the credit worthiness of the issuer of the security is often higher than the seller. Other factors affecting the repo rate include, the credit worthiness of the borrower, liquidity of the collateral and comparable rates of other money market instruments.
A reverse repo is the mirror image of a repo. In a reverse repo, securities are acquired with a simultaneous commitment to resell. Hence whether a transaction is a repo or a reverse repo is determined only in terms of who initiated the first leg of the transaction.
When the reverse repurchase transaction matures, the counterparty returns the security to the entity concerned and receives its cash along with a profit spread. One factor, which encourages an organisation to enter into reverse repo, is that it earns some extra income on its otherwise idle cash.
The increase is the fourth in 15 months and takes the reverse repo, the rate at which it drains funds from the money market, to its highest in nearly three years. The RBI last raised the reverse repo in October, citing inflation pressures from costly oil and robust domestic demand.
Repo rate is the benchmark rate at which the RBI borrows from the banks for short term. An increase in the repo rate may be a pre runner to an increase in the bank rate. The repo rate is the rate at which the RBI borrows from the banks. Bank rate is the rate at which the banks borrow from the RBI. So, if the RBI increases the repo rate, it may increase the bank rate as well in near future.
What would be the impact of these increases o the housing loans? Well generally speaking, the increase in repo rate may lead to a hardening in interest rates across the board. Repo rate increase may lead to increase in interest rates - both lending as well as deposit rates. The banks' funding costs would increase as higher repo rates would trigger a increase in inter-bank borrowing rates and retail deposit rates. The lending rates as reflected in the prime lending rates of the banks and the deposit rates should increase.
However this process takes time. There may be other mitigating factors to watch out before the increase in repo rates does translate into higher cost of borrowings. Due to competition , in the short term the banks may try to attract customers with low floating rate loans.
A lot will depend on the inflation rates and petroleum prices. If these stay under control, then the increase in interest rates may not happen altogether. Many banks are of the view that they would not rush to increase their lending rates. No doubt the increase would enhance their borrowing costs, however most banks would prefer to wait and watch before taking a decision .
Each bank would review rates to see the impact of increasing or not increasing the interest rates. Macro economic indicators still stay strong, which may also help to keep interest rates under control. Also it is to be noted that even if the banks are compelled to increase the rates, it may only be a marginal increase and not a drastic increase