Based on current and evolving macroeconomic situations, the Reserve Bank of India’s monetary policy committee decided to cut the repo rate under the liquidity adjustment facility by 35 basis points from 5.75 percent to 5.40 percent. This is the fourth time in a row that the RBI has cut the repo rate this calendar year (2019). In the last three monetary policy reviews, the rate cut is by 25 basis points.
Repo rate is the benchmark-lending rate at which the central bank of the country lends money to commercial banks for about 7 to 14 days in the event of any shortfall of funds. The repo rate acts as a floor below which the short term interest rates don’t go. The repo rate is used by the central bank to control inflation. A decrease in repo rate means lower cost of short term money which reduces the EMIs on home and auto loans and the debt repayment burden, boosting economic growth.
Why RBI is cutting the Repo rate constantly?
RBI’s cut in repo rate now seems to be not solely focused on inflation but also on growth trends. The capital-intensive industries like Auto and Real Estate are going through a troubled phase due to external and internal factors, so they need cheap capital to accelerate its growth. Growth in these industries also gives a boost to other sectors as well as better employment. The higher growth also means higher taxes for the government which can be used by the government for development. It also means higher inflation in the market due to high liquidity.
Rate cuts also have an impact on private consumption, as presently the households are saving less due to lower interest rates that can affect consumption back and decrease imports. On the global front, economic activity has slowed down and increasing trade tensions in the developed and major emerging market economies has severely impacted India’s exports and investment activity (the main forces to cut the repo rate). Therefore, for boosting domestic consumption and to support investment activities, rate cuts are reinforced.
How a constant cut in repo rate affects the stock market?
A cut in the repo rate sends strong signals to the market about growth in the future. It is one of the most important events in the stock market. Every time when the repo rate is expected to be announced, markets, as well as individual shares, react to it sharply.
The investors and economists view rate cuts as a catalyst for growth, which in turn leads to greater profit as private households enjoy lower interest rates by consuming more and corporates can do financial operations at a cheaper rate, which leads to higher stock prices. The rate cuts will lead to low-interest-rate payments for high debt companies, this interest payment will increase the EPS (Earning Per Share), and thus there will be positive sentiments for such stocks in the market for the short term.
The psychology and expectations of the investors make the market. Let’s understand Psychology first-
If expectation differs from the action of RBI, it can affect the market negatively. For example: if the market is expecting a rate cut of 50bps but RBI announces the drop of 25 bps only, the news can lead to a decline in the stock market due to discounting of 50 bps cut in the repo rate.
The repo rate and stock market are contrarily related. As the repo rate goes down, stock market activities get momentum in expectation of high profit. The company can spend its growth and make more profit via lower debt servicing or high revenue and the estimated amount of future cash flows will rise. So, all factors remaining equal to the stock of the company will rise.
If enough companies experience gains in the stock prices, the index or market will go up and with the higher expectation of growth, investors will start to invest in the market as other avenues of the investment are comparatively less profitable.
Generally, sectors like Pharmaceuticals and IT are less affected by cuts in repo rate in short term and more influenced by factors such as competition from global players, global policy decisions and currency fluctuations.
In a nutshell, when the repo rate is reduced, borrowing becomes easier which means corporates can borrow easily and grow leading to overall economic growth but more liquidity in the hands of corporates and individuals can also lead to increased spending power which can lead to inflation.
As a general thumb rule, when the RBI cuts repo rate, it causes the market to go up, keeping other things constant and when there is a rise In Repo rate it causes markets to go down. So, we can say that the two tend to move in opposite directions. RBI has to maintain a balance between growth and liquidity (inflation) while setting up the Repo rate.