RBI Hikes Interest Rate by 0.4% after Two years: All you need to know

RBI rate hike

The growth, growth, and growth voyage of RBI comes to halt as the country’s apex bank raises the interest rate by 40 basis points after two years. In an unscheduled policy review on Wednesday, RBI governor Shaktikanta Das announced the hike of benchmark interest rate with the aim of controlling inflation.

After prioritizing growth over anything for a couple of years, the Reserve Bank of India finally raises the repo rate by 40 bps to 4.4%. This is the first time in the last two years that the RBI chose to charge more for the money it lends to the commercial banks. The decision to increase the repo rate had already been speculated a few weeks ago when the Reserve Bank warned about rising inflation and said that it will prioritize containing inflation over growth. 

Apart from increasing the repo rate, RBI has also decreased Cash Reserve Ratio or CRR by 50 bps which will result in the withdrawal of Rs 87,000cr liquidity in the system.

Why RBI Increased the Repo Rate?

As said, it was well speculated by all that a hike in repo rate is coming pretty soon amid rising concerns about inflation. A couple of weeks back the RBI governor Shatikanta Das made it clear that the country’s central bank will now be prioritizing to contain inflation over promoting growth. He said that RBI has to put “inflation before growth” in the “sequence of priorities”

Rising Inflation

The data released by the Ministry of Statistics and Programme Implementation last month revealed that the Consumer Price Index or CPI rose to 6.95% in March 2022 and attained a record level in the last 17 months. The retail inflation which was at 6.06% in February spiked by a further 0.89% in March. The level was way over the 6.35% expectations of economists. Furthermore, inflation breached the 6% upper-band set by RBI in the very first three months of 2022. The rise in the Food Index is the major cause behind the overall increase in retail inflation.

If the same continues for April and so, it will become difficult to adhere to the Monetary Policy Committee's mandate. By raising the repo rate, RBI wants to arrest the borrowing and demand in the economy in order to keep inflation under control.

Spike in Government Bond Yields

Recently, the Indian benchmark 10-year government yield also shot up to 7.12%, the highest in the past two years. The bond yield spiked further by 26 bps after yesterday’s announcement of the interest rate hike by RBI. Although it is the speculation about the interest rate hike that has forced bond yields to go up and not the otherwise, the rising yield has been a warning sign of yesterday’s repo rate hike. 

Uncertain Geopolitical Situation

The Russia-Ukraine crisis is still aggravating the already scathing inflation. The rise in crude oil prices which has pushed prices of almost all other goods upwards is very unlikely to stall in the near future. The crisis has also disrupted the global supply chain. The number of sanctions being imposed on Russia by the US and European nations and sharp retorts on the same by Russia have stilled fears and uncertainties in the global economy. In such a situation, one cannot expect the RBI to keep on pumping money into the market and keep inflation aside from the priority list.

Pressure from Global Economies

India came late, but the reaction to rising inflation is well witnessed by big economies like the USA, Russia, and European countries. The US Fed has also raised the rates by 50 and half bps recently. This is the biggest hike in the last 20 years and also suggested that larger rate hikes are yet to come. All these, along with domestic inflation have put pressure on the Indian economy and RBI to reach global changes. The recent interest rate hike is one and probably the first reaction of the series that is going to continue for quite some time.

Impact of RBI Interest Rate Hike

The ripples of repo rate hike by the Reserve Bank of India will be felt across every sector of the country. From the investing community to the banking sector, reactions will be very apparent. 

How Will the Equity Market React to Interest Rate Hike?

Although the relation of repo rate and equity market is not quite direct, the effects are felt within no time. Yesterday itself, the Indian equity market fell dramatically when investors sensed that the RBI is going to increase the interest rate. On Thursday, it tried to regain the loss but selling pressure continued and the market ended flat. Trading below 17,000 points, Nifty is likely to bear more self-offs in the coming days, which will either keep it volatile or in bear’s grip for quite some time. So, why does the equity market react negatively to the RBI interest rate hike? 

Repo rate is the rate at which the RBI lends to commercial banks. An increase in repo rate means increased borrowing costs for the banks, which in turn, will be reflected in the increase in interest rate of loans lent to general borrowers like us. This will further reduce spending and demand in the economy. Reduced demand will force companies to stop expansion and check production of goods and services. This will halt growth that will compel investors to withdraw money from the market and continuous selling will bring stock prices down. This is not only a theory but the inverse relation between repo rate and stock market has been very apparent in history.

Let us go through the major repo rate changes in the last 15 years and see how the Indian stock market reacted to the same.

DateChange in Repo RateReaction of Indian Equity Market
12 June, 2008Increased by 0.50%Nifty 50 lost around 17%
08 December, 2008Decreased by 1%Nifty 50 gained over 7%
05 March, 2009Decreased by 0.50%Nifty 50 jumped by over 9%
03 May, 2013Increased by 0.50%Nifty 50 gained around 1%
27 March 2020Decreased by 0.75%Nifty 50 gained over 14% in the next month

Here we can see that there is an explicit inverse relation between change in repo rate and the equity market. We may see a similar trend this time as well.

Impact on Debt Investments

When yield rises, bond prices fall, which reduces the profitability from debt investments. This forces debt investors to pull their money out of the market and wait until the bond price rises so that they can earn more. Hence, debt funds may face short to medium term volatility.

Impact on Different Sectors

Change in repo rate does not impact each and every sector of the economy. Moreover, not all the sectors are affected equally, some react more than others. Capital heavy sectors like infrastructure, capital goods, banking and the like are more vulnerable to such changes. The capital intensive companies have high capital or debt in their books, which are affected directly by the change in bank’s policies. On the other hand, sectors like FMCG and IT are less sensitive to changes in interest rates

Effect on Loans and Other Credit Instruments

The increase in repo rate will directly affect the credit prices. Banks, in order to compensate for the higher repo rate, will increase the interest rate they charge from borrowers. Hence, home loans, personal loans and other credit facilities are going to get costlier. This will majorly affect home loan borrowers who have opted for floating interest rates. 

How Will Deposit Rates Change?

Increase in repo rate is not seen as something desirable by investors. It negatively affects the equity market, bond market, borrowing cost, etc. However, one positive thing that usually happens when repo rate rises is an increase in interest rates offered in bank deposits. The interest rate of short and medium term deposits rises immediately, followed by long term deposits. It may take a while or so but we will see attractive interest rates for fixed deposits schemes offered by the banks.

What Should Investors Do?

First of all, there is nothing to panic about! The increase and decrease in repo rate is a normal and healthy way to control key metrics of the economy. It is necessary to control inflation immediately in order to promote growth in the long run. Having said this, it is also true that the hike in interest rate will impact investments directly, and mostly in a negative way. So what can be done?

Mutual funds: If you are planning to invest a lump sum amount of money in mutual funds, look for major dips in the equity market. Pick the funds that invest in companies that rely less on borrowing and have lower debts compared to others. Keep all the SIPs running as they are meant for the long term. We have seen the market going down by over 50% in a year, and see where is it now? 

Debt funds: Avoid any fresh investment in debt funds. If you have heavy investments in debt, you can consider reallocation of your investments. However, if you want to invest in debt funds now, look out for corporate funds and not government securities as the former has higher chances of sustaining the hit as compared to the latter.

Equity investment: Buy major market dips if you can. It is very likely that banking stocks will perform poorly amid higher repo rate. However, the same will not continue for eternity. Check for top banks and wait for opportunities when their prices tank substantially. Keep adding quality stocks, as you will not get good stocks at lower prices every time.

Bank deposits: As said, the interest rate of bank deposits may increase following the hike in repo rate. You can consider putting a lump sum money in in short/medium term fixed deposit plans. When that matures, you can use the same to invest in other instruments that would have started recovering by then.