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Tuesday, July 27, 2010

The RBI has increased the Repo and Reverse Repo rates – should investors be concerned?

Many small investors tend to be oblivious about repo rates, reverse repo rates, economic and monetary policies, and the tools that the RBI has at its disposal to control the supply of money (liquidity) in the financial system. But ignorance is not necessarily bliss.

Here is a simple Q&A to try and understand some of the basics:

Q. Why did the RBI raise the repo rate from 5.5% to 5.75% (‘25 basis points’ is another way of saying ‘0.25%’) and the reverse repo rate from 4 to 4.5%?

A. To keep inflation under control. Recent hikes in the repo, reverse repo and CRR rates had failed to contain inflation, and another round of rate hikes became inevitable.

Q. What causes inflation?

A. An excess of liquidity in the financial system.

Q. Why is there excess liquidity in the financial system?

A. Three main reasons:-

  1. reduction in the repo and reverse repo rates by the RBI during the downturn in 2008 and 2009
  2. continuous inflow of large sums of FII money into the Indian stock markets
  3. larger inflow of remittances from NRIs into India (due to the economic downturn in Europe and USA)

Q. Why had the RBI reduced the repo and reverse repo rates in 2008-09?

A. Higher interest rates earlier had led to a slow down in the economy as industries reduced borrowings at high rates and put expansion plans on hold. The reduction in rates helped to stimulate the economy.

Q. Will raising the rates slow down economic growth?

A. Hopefully, not. The CRR rate has been kept unchanged. The Indian economy is almost back on its earlier growth trajectory, so the availability of money at lower interest rates is being curtailed. Companies are expected to finance part of their capital expenditure from internal accruals.

Q. What is the likely effect of the hike in repo and reverse repo rates on small investors?

A. Banks may have no option but to raise lending rates and deposit rates. An increase in lending rates will reduce profitability for those investors who indulge in leveraged buying (i.e. buying stocks with borrowed money).

An increase in deposit rates may lead to a ‘flight to safety’ (i.e. investors may book profits in riskier stock market investments and reinvest the proceeds in safer bank fixed deposits).

Q. Will the stock markets crash because of higher interest rates?

A. A crash is unlikely. The hike in the repo and reverse repo rates were already ‘discounted’ – which means that it was within expected limits. The 50 points rise in the Sensex today is proof that the market players are not unduly concerned.

Q. Should investors buy, sell or hold?

A. That is a tough question, and will depend on individual investors. Interest rate hikes are not conducive to bull markets, as it raises the cost of doing business and affects profitability. So, the upside may get limited. As it is, the Sensex has been trading in a range for 11 months.

If you want to buy, select only fundamentally strong stocks with a track record of flourishing through several bull and bear phases. If you already have such stocks in your portfolio, hold with trailing stop-losses and ride the bull. Book profits in any second or third rung stocks that you may own.

Please remember that as long as the Sensex trades above a rising 200 day EMA, we are in a bull market. So, there is no reason to sell in a panic, or worry about what happened in late 2007. Setting stop-losses will save portfolios from getting destroyed.

Related Post

What the CRR-SLR-Repo cuts mean for investors

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