There was carnage in the market today. The BSE Sensex fell by over 350 points. In many ways, what happened today was a lot like what has been happening on the day of Infosys results in the past few quarters. The culprit for all the action was the 50 basis point hike in repo rate and reverse-repo rate by the RBI. A rate hike per se was already expected. Infact, a survey of market investors and experts conducted over past 2 days showed that over 80% expected a rate hike. Then why did the market fall so violently.
First of all, we must understand the significance of rate hikes on the market. Interest rates determine the amount of liquidity flow in a country. The lower the interest rate, the easier it is to borrow. When it is easier to borrow, the supply of money in the market increases which tends to drive up prices, leading to higher inflation. Hence, though reduction of interest rates helps business, it negatively affects inflation. Inflation is a huge enemy for any country. As inflation rises, common people are impacted and it also endangers the value of currency. There have been several instances of hyperinflation suffered by many countries in the last century which have created huge systemic damage. Hence, it is critical to keep inflation in check.
To reduce inflation, central banks raise the interest rates. This reduces money supply. However, that becomes a negative for business and the country’s GDP gets negatively affected. For instance, the central bank (RBI) today raised benchmark interest rates—repo and reverse repo—by 50 basis points to 8% and 7% respectively. Repo is the rate at which the RBI lends to banks and reverse repo is the rate at which it borrows from banks. Now, with these higher rates, the cost of loans get pushed up, hurting corporates and retail investors alike. Though broadly speaking, higher rates impact all organizations, it especially impacts some sectors more which depend upon borrowing like Real Estate, Automobile, Banking, Consumer Durables and so on. Hence, the costs in the P&L statement of any company go up leading to reduced profits and lower earnings per share. Profits drive stock markets. It is natural that the stock market would correct itself to factor in this change.
Now let’s come to why the current rate hike came as such a blow to the market. We all know that there is tremendous global uncertainty right now. In the US, there is confusion about raising the debt ceiling as the US is on the brink of default. The Euro Zone has just configured another bailout package for Greece but uncertainty continues on how long this bailing out may need to be continued. Closer home, the recent Index of Industrial Production(IIP) numbers were quite disappointing showing that India’s Industrial output in May 2011 grew at just 5.6 % (y-o-y) which was a lot slower than expected. There is speculation that this could be the start of a slowdown in the economy. All this has been playing on the minds of the investors and the stock market too has been lackluster. With this context, the market needed some good news to go up higher. While inflation at 9.4% is a concern, everybody felt that the interest rate should either stay the same or be raised by not more than 0.25%. But the shocker came when the RBI raised the rates by 0.5%(which is a big thing for an economy of our size).
This dampener to the sentiment coupled with the magnitude of the hike(and potential impact) has led to the big fall seen in the markets today. Futhermore, RBI’s statement that inflation may not moderate for a few more months has made investors more jittery. If that were to happen, further rate hikes cannot be ruled out to control the inflation, which would be even more negative for the economy and the stock market. It is very interesting to see how these hikes have been happening over the last 14-15 months:
Date | Basis point hike to Reverse Repo(%) | Basis point hike to Repo(%) |
July 26, 2011 | 50 (7.00) | 50 (8.00) |
June 16, 2011 | 25 (6.50) | 25 (7.50) |
May 03, 2011 | 50 (6.25) | 50 (7.25) |
March 17, 2011 | 25 (5.75) | 25 (6.75) |
January 25, 2011 | 25 (5.50) | 25 (6.50) |
November 02, 2010 | 25 (5.25) | 25 (6.25) |
September 02, 2010 | 50 (4.75) | 25 (6.00) |
August 27, 2010 | 50 (4.25) | 25 (5.75) |
August 02, 2010 | 25 (4.00) | 25 (5.50) |
April 20, 2010 | 25 (3.75) | 25 (5.25) |
March 19, 2010 | 25 (3.50) | 25 (5.00) |
In my opinion, though I may sound like an ogre for saying this, I would definitely like to congratulate the RBI for this bold move. An interest rate hike is not an easy decision to make as so many corporate forces exert pressure through their criticism and public reactions. But in the end, we must understand that rather than adopting quick fix solutions that would temporarily boost up the market, we need to take care of basic but critical factors like inflation which can create havoc in the long run. Infact, I feel this magnitude of hikes should have been carried out much earlier. The RBI has eased through these hikes over a relatively long period. The next credit policy meeting of the RBI happens on Sep 16th and I feel we may have one final hike of 25 basis points awaiting us then. Once that is done, we could see the start of an interest rate easing cycle from Jan 2012 onwards.
Posts
