Capital Markets and the Repo Rate - How are the two related?

Background

For an economy to grow, that country’s fiscal and monetary policies should complement one another. For India, the growth story has just begun. Dubbed one of the fastest-growing Asian economies, the balance between the economic and fiscal policy is of utmost importance. The Indian government expects the Reserve Bank of India (RBI) to keep the economy running smoothly; if the monetary authority feels the economy is lagging, it slashes the repo rate to make borrowing money cheaper for individuals and businesses. This typically pushes up stock prices and rewards investors with better results.

In the early months of the COVID-19 pandemic, there was a rapid decline in economic activity, and the stock market came crashing down. The RBI responded by slashing rates to an all-time low- and fast forward 26 months later; stocks came storming back. But what happens when the RBI raises interest rates?

What is the Repo Rate?

Like any borrower, banks need to pay interest on their loans too. When a commercial bank needs money, it can borrow from the RBI. The Central Bank charges a rate for the loan called the Repo rate. Commercial banks also need to deposit collateral with the RBI to receive the loan. The banks can use collateral like government bonds and treasury bills.

One of the ways the RBI controls the constant rise in prices, also known as inflation, is through the Repo rate. Increasing the Repo rate makes borrowing more expensive for commercial banks. They transfer this extra cost of interest to their retail borrowers. The retail borrowers would have to pay more interest to borrow a loan from a commercial bank. That will limit the bank’s borrowers from taking out loans. The lesser funds the borrowers have, the lesser money in the market. As the money in the market reduces, so does the spending. That, in turn, reduces the cost of goods and services.

If RBI wants to increase spending, it cuts the REPO rate. The commercial banks will borrow more. They will then reduce interest rates for their retail borrowers. More loans will be taken, and there will be an increase in cash flow in the market. That will cause an increase in the growth of the economy.

The current repo rate is at 4.90% which is 90 basis points above the pandemic levels. The RBI hopes to curb inflation by sucking out the liquidity from the economy and promoting reduced spending. Experts believe that the repo rate could rise all the way up to 6% - 6.15%.

Increasing interest rates reduces the free cash that people have and spend on luxuries like travel, eating out, going to movies, etc. The entertainment industry is impacted to a certain extent by the increase in rates.

Relation between Stock Market & Repo Rate

The stock market and interest rates have an inverse relationship; as we have seen earlier, once the RBI increases the repo rate, the amount of cash available in the market decreases. This means that companies also cut back on their spending on the expansion. This lack of expenditure causes a dip in its growth and will affect the profit and future cash flows. This may lead to a fall in stock prices. An increase in interest rates will increase savings and reduce the flow of capital to the economy.

On the other hand, a decrease in interest rates will increase capital flows to the stock market. This will increase the possibility of higher returns from the stock as the company can go high on the expansion spree.

The impact of these changes is not the same on all the sectors or companies. For example, the capital-intensive sectors like infrastructure, capital goods, etc., are more prone to these changes due to high capital or debt on the books of these companies. On the other hand, stocks of capital-light sectors like IT, FMCG, etc., have a lesser impact on these changes.

Conclusion

The RBI balances the inflation risk and growth in the economy by adjusting the repo rate. The Repo rate is one of the tools available to the central bank to control the money supply. Financial markets react sharply to any signs of such adjustments. As an investor, you should keep an eye on these.