The stock markets have been on a tear this week, with the Sensex closing at its highest levels in the past 30 months. There have been a lot of positives right from good results and monsoon to supportive global markets.
However, one local threat has the potential to spoil the party and most people know it as inflation. Hence, all eyes are now set on the Reserve Bank of India's credit policy meeting on July 27. There is generally a lot written in the press or discussed on business channels, but what really is the significance of this exercise and how does this affect you?
A credit policy meeting is chaired by the RBI Governor to ensure price stability in the economy and regulatory norms for the banking and financial services sector. RBI is responsible for framing and implementing the credit policy.
It basically regulates the cost and availability of credit in the economy. RBI can increase or decrease the supply of currency as well as interest rates, carry out open market operations, control credit and vary the reserve requirements.
Most economists say we are in for at least a 25-basis point (bp) rise in the repo and reverse repo rate, whereas most believe the cash reserve ratio (CRR) would remain at the current level of six per cent. Some aggressive economists do not even rule out a 50-bp rise in repo at the meeting.
While economic growth is robust and headline inflation has been in double digits for five months, tight liquidity after the 3G auctions and continued uncertainty about global markets will prevent RBI from taking aggressive exposure of tightening interest rates.
It has already raised rates thrice this year, by 25 bps each time, most recently in an unexpected move on July 2. Hence, it is unlikely that a 50-bp repo rate hike is on the cards.
Credit policy decisions affect consumers in borrowing, investments and costs of products, as detailed:
Borrowing/Lending: An increase in interest rates would force banks to increase their lending rates and borrowing rates. This means if you want to take a loan, the interest rates could be higher than they are currently.
On the other hand, your fixed deposit could fetch you a higher rate of interest. Similarly, a reduction in rates will lower the cost of borrowing, while reducing the interest rate on your deposits.
Investments: Besides deposits, an increase in rates also has an impact on the debt markets and debt mutual funds. An increase in rates can cause bond yields to go up, while prices of bonds would come down (as bond yields and prices share an inverse relationship).
At the same time, there is an impact on the stock market because of interest rate changes. The factor connecting money and stocks is interest rates. People save to get returns on their savings. Bank deposits and bonds are competitors to stocks when it comes to people's savings.
A rise in interest rates would take money out from stocks and into bonds, whereas a fall in interest rates would move money out of bonds and deposits and into stocks. On the sectoral front, bottom lines of banks are affected because of interest rate changes. A bank with lower cost of deposits will have an edge over its competitors in pricing power.
A bank can keep its rate lower and increase volumes, while other banks are forced to raise rates. At the same time, interest rate-sensitive sectors such as realty and auto can remain a little soft if interest rates go up sharply. This is because the increased cost of borrowing can dampen demand.
This can affect fast moving consumer goods (FMCG) companies and others based on retail demand. It could be time to move out of some FMCG stocks, often considered to be defensives, and rebalance one's portfolio.
A 25-bp hike seems to have been factored by the market and hence market pundits do not really expect fireworks on the downside because of a 25-bp hike. In short, a 25-bp hike will have a neutral to a positive impact on the market. An unlikely 50-bp hike can cause a short-term jolt in interest rate-sensitive sectors and the market in general.
The key challenge for the RBI over the next two-three quarters will be to peg back inflation without hampering growth. We faced a similar situation in 2004 and RBI then did a good balancing act of controlling inflation while maintaining growth. It can do an encore this time as well.
RBI's credit policy also affects the risk weightage of different sectors and hence loans - home, commercial, education and so on. Higher the risk weightage of a sector, the riskier it is perceived to be and loans rates are likely to move up.
As a result, banks have to set aside more capital to maintain their capital adequacy ratio. If the risk weightage is lowered, a bank has to set a lower CAR and will have more money at its disposal pushing down interest rate.
The RBI can also bar banks from lending to certain sectors (like real estate) or types of loans (loan against property). If banks cannot lend to developers, their cost of borrowing goes up and increases property prices. Similarly, if education is classified as priority sector and its risk weightage goes down, interest rates will go down.The writer is a certified financial planner