In a surprise move on Wednesday, the Reserve Bank of India (RBI) increased the key interest rate by 40 basis points to tame inflation that has remained stubbornly above target in recent months. The announcement immediately pushed equity benchmarks to slump sharply with BSE Sensex plunging more than 1,400 points in the intra-day trade to close at 55,669.03. While the NSE Nifty settled below 16,700 after recording a fall of 391 points.
The increase in repo rate – the rate at which the RBI lends to commercial banks – to 4.40 per cent from a record low of 4 per cent is the first since August 2018 as well as the first instance of the RBI governor-headed monetary policy committee (MPC) holding an unscheduled meeting for raising interest rates.
What is Repo rate
Repo rate is the interest charged by the RBI when commercial banks borrow from them by selling their securities to the central bank. Essentially it is the interest charged by the RBI when banks borrow from them – much like commercial banks charge you interest for a car loan or home loan.
Repo rate’s relation with the stock market
The stock market and the interest rates have an inverse relationship. Every time the central bank increases the repo rate, its immediate impact is seen on the stock markets. This means that following the hike in the repo rate prompts companies to also cut back on the spending on the expansion, which leads to a dip in growth and affects the profit and future cash flows, resulting in a fall in stock prices.
If several companies follow this suit, it eventually leads to a fall in markets.
In a nutshell, an increase in interest rates means an increase in savings and a reduction in the flow of capital to the economy, which results in slump in stock markets..
Further, the impact of the change in repo rate down does not have the same effect on all sectors. For example, the capital-intensive sectors such as capital goods, infrastructure, etc, are more vulnerable to these changes due to high capital or debt on the books of these companies. While stocks of sectors like Information Technology (IT) or Fast-moving consumer goods (FMCG) usually see a lesser impact.
(With agency inputs)