Today Indian Stock Markets crashed more than 2% mostly due to hike of repo rate by 40 bps to 4.4% by the RBI. Most of the beginners may think why market crash today? Why interest rate hike impact negatively on stock markets? So, in this chapter we will know some basic concept of central bank interest rates and their impact on stock markets.
Table of Contents
- What is REPO rate
- What is Reverse REPO rate
- What is CRR (Cash Reserve Ratio)
- What is inflation
- Inflation & Interest rate hike impact on market
- Conclusion
Central bank, that is Reserve Bank of India in case of our country, changes interest rates to tackle the inflation by decreasing or increasing the liquidity in the market. For which they change the central bank interest rates according to their policy. There are various types of rates you may heard about in news articles but two types of rate that directly affect bank customers are REPO rate and Reverse REPO rate. Other rates affect banks and also indirectly affect us like the CRR. So, let’s know the basic definition of these central bank rates.
What is REPO rate
REPO (Repurchasing Option) rate is the interest rate RBI charge on short term loans it gives to the commercial banks. When the central bank increases repo rate then the banks also tries to pass on this to its customer by increasing the interest on loans and most of the loans like home loans, personal loans etc becomes costlier and the EMI increases.
What is Reverse REPO rate
Reverse REPO rate is the interest rate RBI gives on the money it takes from the banks in case of needs. Generally the Reverse REPO rate is less than the REPO rate. When RBI increases the reverse repo rate then the commercial banks earns more interest on their deposits and also offers more interest on deposits (mainly on fixed deposits) to its customer.
What is CRR (Cash Reserve Ratio)
As per the rules of RBI, all banks have to keep a percentage of its total deposits reserved at RBI that is called as CRR (Cash Reserve Ratio). The bank will not earn any interest on that deposited amount and neither can use it for giving loans or to invest anywhere. If the central bank increases the CRR then the commercial banks have to deposit more money as reserve on which they will not get any return, so it impacts the profitability of the bank.
As we know the central bank change these Repo Rate, Reverse Repo Rate, CRR and other bank rates to control the inflation and liquidity in the market, so first we must know what is inflation and liquidity.
What is inflation
Generally inflation means rise in prices or the rate of increase in prices of goods and services that we use. When inflation increases then the price of goods or products we use in day to day life increases or you can say when prices of goods and services increases then we say it rise of inflation. The rate of change is calculated by measuring the percentage of rate of change in prices compared to the prices in the base year (currently 2012 is taken as base year). In India there are two types of indices used to measure inflation.
Wholesale Price Index (WPI) – That is the average price of a basket or group of wholesale goods, products and services.
Consumer Price Index (CPI) – That calculates average of retail prices of a group of commodity goods, products and services.
As per economics when demand of any product increases or supply decreases then the price of that product increases. And when purchasing power of consumer increases then also prices increases. In simple words, if any item is not sufficiently available in the market (that is shortage of supply) and more people wants to buy that item (increase in demand) then customers (who have more money or purchasing power) offer more prices for that item which increases price of that item. That is why inflation increases. In this case the purchasing power increases mainly due to liquidity, that is availability of more money in the market.
Therefore the central bank take steps to pullout the excess money from the market by increasing the interest rates. When bank interests increases then loans becomes costlier and bank deposits gives more returns, hence people are discouraged to take loans and encouraged to deposit more money in bank accounts. In this way the excess money sucks out of the market.
Inflation & Interest rate hike impact on market
So, when the central bank or Reserve Bank of India increases the interest rates to handle the inflation rates, people tend to invest their money in bonds and fixed deposits as they earn more interest. And if they get similar or slightly less return without taking any risk then why they invest in riskier assets like stocks or mutual funds. Hence they pullout money from the stock markets and invest in these assets, because bank deposits are considered as safe & risk free or less risky assets.
When bank interests are low then people don’t want to deposit money in bank accounts, rather wants to invest them in more profitable sources like stock markets. Also when loans are available at cheaper rates, then many people and institutions draw loans and invest them in stock markets to get more return. But when the interest rates increases then people starts to withdraw their money from stock markets back to banks.
When bank interests are low then businesses avail loans at cheaper rates and they get more loans to invest in their business, which helps to expand their business and also increases the profit margin. But when interest rates increases the companies have to pay more interests on their loans. It impacts their profit margin and financial results. Weak results by companies negatively impact market sentiments and market tries to factor in it on its stock price.
Conclusion
These are some basic fact due to why the stock market crashes when central bank increases interest rates. But all these reasons are short term in nature, because generally good stocks give more returns than any other assets in long run. Also if we look at the past returns of the bench mark indices like Nifty 50 & BSE Sensex, it has given nearly 15% yearly returns, which is far better than any other assets. So investors who have good knowledge and experience in the market don’t bother about these short term negativity and crashes, rather use it as an opportunity for value buying.
But all this depends on your own analysis, if you have confidence on your portfolio stocks. Otherwise you should consult your financial advisor before making any investing decision. All the information we have provided here is only for a basic knowledge and educational purposes.
