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What is the repo rate, and why is it important for the stock market

ICICI Securities 25 Jan 2022 0 COMMENT

Introduction

Like any borrower, banks need to pay interest on their loans too. When a commercial bank needs money, it can borrow from the RBI. The Central Bank charges a rate for the loan called the Repo rate.

Commercial banks also need to deposit collateral with the RBI to receive the loan. The banks can use collateral like government bonds and treasury bills. Once the loan tenure is completed, the banks can repurchase these bonds and bills from the RBI. Hence, this tool that allows commercial banks to borrow is called the repurchase option or agreement.  

Effect of Repo rate on the economy:

One of the ways the RBI controls the constant rise in prices, also known as inflation, is through the REPO rate. Increasing the REPO rate makes borrowing more expensive for commercial banks. They transfer this extra cost of interest to their retail borrowers. The retail borrowers would have to pay more interest to borrow a loan from a commercial bank. That will limit the bank’s borrowers from taking out loans. The lesser funds the borrowers have, the lesser money in the market. As the money in the market reduces, so does the spending. That, in turn, reduces the cost of goods and services.

If RBI wants to increase spending, it cuts the REPO rate. The commercial banks will borrow more. They will then reduce interest rates for their retail borrowers. More loans will be taken, and there will be an increase in cash flow in the market. That will cause an increase in the growth of the economy.

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Let us now look at the importance of the REPO rate in the stock market.

The stock market and interest rates have an inverse relationship. As we have seen earlier, once the RBI increases the repo rate the amount of cash available in the market decreases. This means that companies also cut back on their spending on the expansion. This lack of spending causes a dip in its growth and will affect the profit and future cash flows. This may lead to a fall in stock prices. If several companies follow suit, the whole market or indexes will also fall. An increase in interest rates will increase savings and reduce the flow of capital to the economy. Because of higher interest rates in the market, people prefer to invest more money in the fixed income instrument due to a fall in the equity premium. Equity premium is the difference between equity returns and risk-free returns.

On the other hand, a decrease in interest rates will increase capital flows to the stock market. This will increase the possibility of higher returns from the stock as the company can go high on the expansion spree.

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The impact of these changes is not the same on all the sectors or companies. For example, the capital-intensive sectors like infrastructure, capital goods, etc., are more prone to these changes due to high capital or debt on the books of these companies. On the other hand, stocks of capital-light sectors like IT, FMCG, etc., have lesser impact with these changes.

Additional Read: Nifty comes off 15,000 mark; RBI keeps repo rate unchanged

Conclusion

The RBI balances the inflation risk and growth in the economy by adjusting the repo rate. Repo rate is one of the tools available with the central bank to control the money supply. Financial markets react sharply to any signs of such adjustments. As an investor, you should keep an eye on these developments.

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