The repo rate is the rate at which the RBI gives loans to commercial banks. It is a weapon to control inflation in the economy. When the inflation is more than the expected levels, the central banks increase the repo rate. Due to this hike loans and other EMIs become expensive and which lowers the demand and circulation in the financial market. The Reverse Repo Rate is the rate at which the central bank borrows money from commercial banks. It is a Central Bank monetary policy tool that can be used to control the country’s money supply. If the Reverse Repo Rate increases, the money supply falls and vice versa. If the Reverse Repo rate increases, commercial banks will be attracted to deposit more funds in RBI and will reduce the amount of money in the market.
In May, 2022 RBI decided to increase the repo rate by 40 basis points (bps) in an off-cycle meeting, citing the concern for inflation. This was the first increase in the Repo- Rate in last 44 months since August 2018. Later on, in the month of June Reserve bank governor again announced the increase in the rate by 50 basis points to set repo rate at 4.90 percent. This was the second consecutive increase in the repo rate in this year. The report further says, there are expectations that the RBI could contribute in rate hike in August (as inflation in June is likely to reach above 7 percent) and RBI wants to lower its inflation as per the pre–pandemic level by October 2022 i.e. 5.5 percent.[i]
IMPACT OF RBI RATE HIKE ON FINANCIAL SECTOR
Reserve bank has increased Repo Rate by 90 basis points in the last two months and it is expected that there will more upward movement in the repo rate till the end of December 2022 said to the Monetary Policy Committee in recent meetings. Repo Rate refers to the rate at which the Reserve Bank of India lends money to all the commercial banks in the country. So, when the Repo Rate increases, it makes the borrowing costs for the banks, which leads to an increase in lending rates to the customers by them, thus passing this burden to the end customer. Following Impacts can be observed in the financial sector after the rate escalates: –
- Inflation – When the Repo Rate increases, banks are compelled to pay more interest to the Reserve Bank of India which prompts them to shoot up their lending rates for their customers. As a result, the borrowers often hesitate to take credit from the banks which leads to a shortage of funds and liquidity issues in the economy. So, inflation falls as there is less money in the hands of the public to spend.
- Fixed Deposits – With the increase in Repo Rate, the availability of funds for the commercial banks is scarce as the banks are not ready to borrow the funds at the higher rates. To get the deposits, Domestic banks have to surge their interest rates on deposits to attract more depositors. Hence, it leads to an increase in interest rates on fixed deposits.
- Borrowings – Most financial experts have a point of view that the impact of elevation in the repo rates might not necessarily get translated immediately into the higher rates on the deposits. But it is not the case; the borrowings become more expensive as well when the rates on loans move upward.
- Home Loans-For the existing borrowers, the burden of EMI would only increase as the banks will start increasing their interest rates. However, borrowers will get to know about such an increase in interest of EMI only when the reset dates of their loan arrives.
- Economy-According to the experts, increasing the repo rates was the right move by the RBI with the global backdrop of the Fed’s rate policy, rising oil prices, and the fact that many emerging economies have already increased their rates. Emerging markets are hiking rates for defending their currencies. However, some experts are also worried that this increase in repo rate might put a dent in the growth rate, which was recovering after blows from demonetization and the launch of GST.
How Rate Hike Will Impact Equity Investments?
Equity investments are the amount invested in the stock market by buying shares of a particular company. These shares are traded on the stock exchange (i.e., BSE & NSE in India). Equity investors invest in the companies by buying shares of that specific company and expect a rise in the value through capital gains and also generate dividends. Mutual funds are also a kind of equity investment, as the money invested in mutual funds is further allocated in shares, bonds, foreign investments, etc.
- Repo rate impact on Stock Market:- Stocks and interest rates have an inverse relationship. Whenever the central bank hikes the repo rate, its immediate impact is seen on the stock market. This means that the hike in the repo rate results in companies cutting back on the spending of the expansion, which leads to a decrease in growth and affects the profit and future cash flows, resulting in a fall of stock prices. Especially the new investors in the equity market get affected by the increase in Repo Rate by RBI as they shift their investment from equity to fixed investments like FDs where the interest rates are increasing currently and these are a safe way of investments. Further, the result of the change in repo rate does not have the same effect on all sectors. To illustrate, the capital-intensive sectors such as infra, and capital goods are more vulnerable to these changes due to high capital or debt on the books of these companies. While stocks in the sectors like Information Technology (IT) or Fast-moving consumer goods (FMCG) will be less affected.[ii]
- RBI Rate hike impact on Mutual fund Investments: -Mutual fund industry also has a bad impact, as investors hesitate to invest their fresh money in mutual funds and they often prefer to invest in fixed income investments like FDs. Large-cap mutual funds are expected to perform well in the future as compared to investments in small-cap companies.[iii]
- Effect on debt mutual funds: -Net asset value of a debt fund is connected with the prices of bonds. If the repo rate will increase bondholders will demand more interest on new bonds and the demand and prices for existing bonds will be reduced. Thus, the debt fund NAV will fall. The existing debt fund investors must avoid any reaction without any serious thought at this point of time; it is often suggested to hold their investments.
- Effect on Long term Mutual Funds: – The least impact is expected on the investors who have the large-cap funds as money is invested in businesses that have a lot of cash on hand and can function without taking out loans at excessive interest rates. [iv]
To recapitulate, the hike in the Repo rate by RBI will affect positively as well as negatively the financial sector and Equity investments. In the financial sector, inflation will be wiped out, and rates on banks’ deposits will increase due to a hike in the Repo rate, also on the other side borrowings will be expensive for the banks and the banks consecutively hike their lending rates for their customers.
In equity investments like share and mutual funds, some sectors will be considerably affected by the rate hike such as companies with capital-intensive industries like real estate, companies with high debts, and other hand sectors like Pharma, companies with zero debt, FMCG, etc. Therefore, these sectors will be least affected by Rate hikes. Also, in a mutual fundss, long-term funds will not be affected at all but there will be a serious effect on small-term debt funds because the investors are not prepared to put their fresh money in the mutual funds for the short term and they prefer FDs over it.
[i] Shubham raj, RBI RATE HIKE –Is it negative or positive for equity investors, Economic times (jun.08, 2022, 06:14 PM), Rbi Rate Hike impact on investors: RBI’s rate hike – is it negative or positive for equity investors? Experts decode – The Economic Times (indiatimes.com)
[ii] Jayant Makkar, Repo rate and stock market, Taxguru (jan. 06, 2015), https://taxguru.in/finance/repo-rate-stock-market.html
[iii] Sangeeta ojha, what is the impact of RBI rate on mutual fund investment, livemint.com (08. May ,2022 , 9:03 AM, https://www.livemint.com/mutual-fund/mf-news/what-is-the-impact-of-rbi-rate-hike-on-your-mutual-fund-investments-11651970345651.html
[iv] Sangeeta ojha, what is the impact of RBI rate on mutual fund investment, livemint.com (08. May ,2022 , 9:03 AM, https://www.livemint.com/mutual-fund/mf-news/what-is-the-impact-of-rbi-rate-hike-on-your-mutual-fund-investments-11651970345651.html