How does the Indian monetary policy affect the Indian stock market?

Today, let’s talk about how the decisions made by India’s central bank, called the Reserve Bank of India (RBI), can affect the Indian stock market. In countries like India, the central bank plays a pivotal role in cross-checking the functioning of all the banks in the country. 

One of its main duties is to control inflation and also make sure that there’s enough liquidity in the economy. They are also responsible for keeping the value of the Indian rupee steady. The RBI controls this by restructuring India’s monetary policy every two months. 

Now, you might wonder, how does the Indian monetary policy affect the Indian stock market? Well, let’s try to find it out here.

RBI and Indian monetary policy 

Before understanding the impact of the Indian economy’s monetary policy on the stock market, it is necessary to know how the RBI functions and controls the flow of money in the economy. 

The RBI, which is like India’s financial guardian, tries to maintain financial stability in the country. One key tool it uses to achieve this is the Indian monetary policy. Under this, it controls two instruments- the repo rate and the reverse repo rate. 

The repo rate is the interest rate RBI charges when it lends money to banks whereas the reverse repo rate is charged by banks when it lends money to the RBI. These interest rates help control the liquidity in the market. 

RBI is also responsible for open market operations (OMO). Here, the RBI opens up bonds for the open market to control the money flow. This doesn’t affect the interest rates, but it does impact the buying and selling of stocks both in the Indian and global stock markets. 

Impact of indian monetary policy on stock market

Let’s take a quick look at how the decisions made by the RBI can influence the stock market in India. Since 2015, when the RBI started cutting interest rates, we’ve seen some interesting trends. 

For example, during this period, while the overall market (Nifty) gave a yearly return of 7%, the banking sector (Bank Nifty) outperformed with a 12% return. This was because the RBI slashed the interest rates by 275 basis points, thus benefiting the financial companies. This clearly shows the effect of monetary policy on Indian economy. 

After seeing an example, let’s try to understand the reasons behind how does the Indian monetary policy affects the Indian stock market- 

1. Decrease in policy rates

When the RBI lowers policy rates like repo rate or cash reserve ratio, it’s called expansionary monetary policy. This means banks can borrow money from the RBI at lower interest rates. As they are themselves enjoying the benefits, they will surely pass on these savings to their customers, who are mostly businesses or individuals. 

As interest rates go low, businesses can get cheaper loans thus reducing their overall debt costs. In the stock market, a company’s stock price directly reflects its expected future profits. If the interest rates are low, this means the value of their earnings will automatically go up, pushing their stock prices even higher. As a result, stock indices will rise. This partially shows how the Indian monetary policy impacts the stock market when policy rates are lowered. 

2. Increase in policy rates 

When the RBI raises policy rates, the opposite happens. Borrowing money from the RBI becomes more expensive for banks due to increased repo rates. This in turn increases the reverse repo rate. This is often done to soak up the liquidity in the market. These higher costs are then passed onto the bank’s customers, like businesses and individuals, making loans expensive. Businesses are forced to pay more for loans, increasing their overall costs. 

These higher interest rates affect businesses’ future earnings making them worth less. This leads to a drop in stock prices. As a result, stock indices decrease. This explains the monetary policy impact on Indian economy when policy rates increase. 

3. Impact on rate-sensitive sectors 

Many sectors in the Indian economy come under rate-sensitive sectors. They include banks, non-banking financial companies (NBFCs), automobile companies, real estate companies and much more. Overall more than 50% of stocks listed in the Nifty index come under rate-sensitive sectors and are impacted by the Indian economy’s monetary policy. 

When interest rates go down, these sectors flourish, while on the other side if interest rates go up these sectors struggle. As half of the Nifty index is made up of rate-sensitive companies, whenever interest rates change, it impacts almost half of the total market.

These rate-sensitive sectors not only get impacted when interest rates actually change but also get impacted by news of future changes by RBI. For example, if everyone expects the RBI to raise rates by 0.5%, but they decide not to, it still affects the stock market. 

This is because investors make decisions on what they think will happen in the future. So, even the RBI’s future plans to change the monetary policy can have an impact on the Indian economy. 

4. Companies can reduce their financial risk

The Indian monetary policy helps companies reduce financial risks by changing interest rates frequently. This helps improve the financial health of these companies as well. This did happen in 1995-96 when the RBI, led by Dr C Rangarajan, raised interest rates a lot to control inflation. This hurt many companies because they had borrowed a ton of money and couldn’t handle the higher interest payments. 

But whenever RBI reduces rates, companies get to borrow cheap loans. This reduces their debt burden and makes their financial situation safer. As a result, their stock prices go up because investors see them as less risky investments. So, when interest rates change, it can affect how investors view companies and the stock market as a whole.

Impact of liquidity on stock market- taper tantrum example 

The amount of money circulating in the economy does have an impact on the stock market. In situations of high liquidity and inflation, the central bank usually stops buying bonds and starts selling them in the open markets. This move helps to suck up money from the economy and control the rising inflation. 

This did happen in the past and is famously known as the Taper Tantrum of 2013. This happened in the US where the US Federal Reserve decided to stop buying bonds after the big financial crisis in 2007-08. This made it harder to get money in the US, leading to a sell-off in stock markets. This not only affected the US markets but also left the Indian markets suffering. This affected Nifty returns drastically. 

Conclusion 

In conclusion, monetary policy refers to decisions made by a central bank, like the RBI, regarding interest rates and money supply. These decisions do impact the stock market in the ways we discussed above. To stay safe, investors should stay informed about RBI’s actions and their potential effects on the market. One can opt for diversified investments, through analyses of economic indicators, and seeking professional advice to help reduce the risks associated with these Indian monetary policy changes.

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