Central Banks play a pivotal role, and in developing countries like India, this role becomes even more important. The central bank has to monitor the functioning of all the banks in the country, it also has to maintain price stability by keeping inflation in control. Ensuring adequate liquidity in the economy, apart from maintaining currency stability, are other responsibilities. These were some of the main tasks of the central bank of any country. These policies also impact the Indian stock markets, which we will see in this article.
Functions and Tools of the RBI
It is the central bank that maintains financial stability in the country. To achieve this stability, one of the key tools with the RBI is the Indian monetary policy. In this policy, the main focus is on benchmark policy interest rates in the country that is known as repo rate (or the repurchase rate) and reverse repo rate.
The Repo rate is the rate at which the central bank lends to commercial banks, and conversely, the reverse repo rate is when the commercial banks lend money to the RBI. This is how Indian monetary policy works in a nutshell.
The other tool with the RBI is open market operations (OMO), in which the RBI buys or sells fixed income instruments like bonds in the open market. The objective is again to maintain adequate liquidity in the market, with a difference that there is no playing with interest rates here. This bond purchase and selling program also impacts the stock markets globally, including the Indian stock market.
Impact of Monetary Policy on Stock Markets in India
In this section, we will see how the change in benchmark policy rates or bond purchase program affects the Indian stock market. Here it goes:
When the RBI reduces the policy rates (repo rate, reverse repo rate, cash reserve ratio, statutory liquidity ratio), it is known as expansionary monetary policy. Now, when the repo rate is decreased, it means commercial banks can now borrow money from the RBI at lower interest rates. Thus, they will ideally pass on this benefit to their customers that are both retail and corporate borrowers. Corporates will now get access to capital at a cheaper rate bringing down their cost of debt.
This reduction in the cost of debt subsequently reduces the cost of capital for the company. In the Indian stock market, the stock price of any company is the present value of all the future cash flows that the company is expected to generate. The discount rate has come down now, which means a higher value of the stock, which will eventually reflect in its price. When the stock price increases, the stock indices all go up. This is one way to study and analyze how Indian monetary policy affects the stock market.
On the flip side, when the RBI increases the policy rates, the reverse of the above phenomenon occurs. Cost of debt increase will lead to the cost of the capital increase that will increase the discount rate and thus decrease the value of the stock.
Reduction in interest rate means reduced interest expense for the company that reduces the operational expenses of the company. Even if the revenue is constant as compared to last year or increases modestly with lower operational expenses, the bottom line (i.e., the profit) is increased. This will reflect in the quarterly and annual financial results of the company impacting its share price in the medium to long term.
Real-Life Example from Indian Stock Market
The CAGR (compounded annual growth rate) returns of Indian stock market indices Nifty was 7%, while that of Nifty Bank was 12%, in the three-year period between January 2015 and January 2018. In the same timeframe, the RBI has reduced the repo rate by 200 basis points (100 basis points = 1%) and bank rate by 75 basis points.
Impact of Liquidity on Stock Market
We will now see the impact of decreased liquidity in the economy through conducting Indian monetary policy on the stock market performance. When the central bank stops purchasing bonds from the open market and starts selling them in open market operations, it sucks the liquidity from the economy. This is usually done to curb inflation by reducing the amount of currency circulation in the market.
The reduced liquidity is usually not welcomed by retail and institutional investors (both domestic and foreign). An outcome of this is a sell-off in the stock markets leading to a panic situation among investors. This liquidity crunch also has an impact on the currency as it starts getting depreciated in the currency market, which further hurts the trade basket of that country.
Real-Life Example: Taper Tantrum
Taper Tantrum is the name of a phenomenon that occurred in 2013 in the US and had its effect on the Indian stock market as well. The central bank of the US Federal Reserve decided to stop the bond purchasing program in 2013, which was started after the Global Financial Crisis of 2007-08. This program is also known as Quantitative Easing (QE).
Now, this news will lead to a liquidity crunch in the US economy and what followed was a sell-off in the equity markets. This sell-off was not limited to the US, it reached the Indian stock markets as well. Nifty returns were a modest 6.8% in 2013, down from 27.7% returns a year ago in 2012 due to a massive sell-off.
This is all we had for you in this edition of how Indian monetary policy affects the stock market. We hope you have better clarity on the cause and effect between the central bank activities and their impact on the Indian stock market. To start your journey in the stock markets, open a Demat account with Angel One at one of the lowest brokerage fees. Allow us to serve you!!