How does the cut in Repo rate affect the liquidity of Indian economy?

The RBI reduced its repo rate by 100 basis points with immediate effect, a move that will help lower interest rates and spur consumption to keep the economy up beating. With this the repurchase rate will stand reduced at eight per cent now. The central bank decision has come at the right time as the economy has begun to come under the pressure of global slowdown. The sharp 100 basis point cut in repo with immediate effect is seen as a clear signal to banks to reduce interest rates. The repo is the rate at which the RBI lends money to banks against the collateral of government securities. This is the first time in five years that the RBI has cut the repo rate, the last being in August 2003 by 0.5 percentage point to 6 per cent. In fact, RBI had raised short-term key rates several times in the past three years to control the rising inflation. The head of a public sector bank pointed out that before affecting a lending rate cut, banks will have to lower deposit rates, which have risen substantially in the last three months.

For the middle class, the big news is the home loan rate cuts—tentative at first, but bound to snowball. The government also held out the likelihood of a major expenditure boost to spur demand across sectors. Since RBI will announce its half-yearly credit policy soon, another tranche of rate cut is on the cards.

This could translate into lower interest rates on house loans, car loans and other consumer loans, bringing cheer to retail borrowers, consumers and businesses.
Industry executives expressed scepticism on immediate relief because the banking system is facing liquidity crunch forcing lenders to push rates higher. To worsen the situation, an anticipated downturn in economic growth exacerbated the cautiousness. The problem is that liquidity is not being sustained in the market. The RBI is infusing liquidity by sucking out rupees. It's not clear if this would improve liquidity. In normal circumstances, the central bank measures, including a cut in the cash reserve ratio and followed by a repo rate cut, would have boosted liquidity and reduced interest rates immediately, but RBI is tackling several variables including controlling inflation, infusing liquidity and ensuring the rupee doesn't depreciate further, which works at cross purposes.

What is the link between the repo rate and the bank rate? The repo rate is the rate at which the RBI borrows from the banks, while the bank rate is the rate at which the banks borrow from the RBI. Naturally, then, if the RBI cuts the repo rate, it may not be long before it cuts the bank rate as well.
A cut in the bank rate could set off a series of rate reduction on fixed-income instruments. Banks, for instance, will lower the interest rate on their fixed-deposits. There could also be a small reduction in the loan rates they offer companies.
The repo rate has a direct bearing on the overnight or the call money market; this is the market where banks and primary dealers borrow money for one day to, typically, 14 days.
How does repo rate relate to the call rate? Repo rate typically acts as a floor rate for the call rate. If not, banks would make arbitrage profits. How? Suppose call rate is lower than repo rate, banks will borrow on call (if there are lenders) at a lower rate, and lend on repos to the RBI at a higher rate. As repo acts as a floor, a cut in repo rate will also lower call rates. And this would depress the returns from money market mutual funds that invest (lend) in the call market.

The central bank had cut CRR by 250 basis points from the fortnight beginning October 11, releasing Rs 1,00,000 crore into the banking system and relaxed the Statutory Liquidity Ratio by 0.5 percentage point enabling banks to borrow more funds from the apex bank. The RBI had also granted a Rs 20,000 crore special liquidity facility to mutual funds to ease their redemption pressure. In short over the last week, RBI and the central government infused Rs 1.45 lakh crore in the system through a slew of measures. These measures seem to have led to a condition of excess liquidity in the system. With this excess liquidity, the banking system of the country can regain its lost confidence out of global slowdown. But we have to wait and see how the system reacts with these measures? Also we have to watch closely the inflation figures. Time and again, the country proved that its economy is strong and well controlled and can get away with any contagious effects from global financial problems.