On May 3, the Reserve Bank of India announced the annual monetary policy and soon after, stock markets dipped 2.5%, with some stocks falling as much as 10%. Our monetary policy is one of those things no one really cares about until it gets to a point where it hurts them — and this is such a time. It sometimes isn't entirely clear why the RBI's actions should impact the stock market, so let's take a look.
A few things in the policy were specifically geared towards arresting inflation, which, after being out of hand for over a year, is now officially out of hand. It has not been about onion prices; the general price index at the "Primary Articles" level has been over 12% for nearly one-and-a -half years now. The US Fed, which has been countering inflation by pretending it doesn't exist, has recently mentioned that price rises are "transitory"; you just pay more on the way to a place where, by sheer luck, you pay even more. India is already there.
To curb inflation, the only tool that the RBI will use is their policy interest rate. Raising interest rates makes money more expensive, and while it will raise everyone's costs, the higher cost will mean lower demand and therefore people reduce their output or cut prices to stay in business. The trade-off is always between raising rates too high and hurting growth too badly, and letting them stay too low and letting inflation get out of hand.
For us, with a few years of very strong growth and high inflation now, interest rates were bound to go up, and they did. The RBI has raised rates about 2% in a "tightening" cycle but it has had little impact on inflation — in fact, inflation is increasing and spreading. But the big reaction on this statement is due to the change in RBI's stance — that it will tackle inflation even at the expense of growth, with a 0.50% hike instead of the regular 0.25% it has been doing.
The RBI policy is no longer a statement in black and white. People read between the lines to see whether this word is stronger than that word they used last time. News sources call tones "hawkish" or "dovish", analysts interpret body language and average pauses between sentences and so on to guess what the RBI will do in the future. Till now, the RBI has taken the stance that growth is just as important and that inflation, while a problem, will not be addressed by hurting economic growth. Now, it's gone the other way — that lower growth is acceptable, that inflation is the bigger monster. Which means it's not nearing the end of the cycle of interest-rate hikes, as was popularly believed from interpretations in earlier RBI statements. And that spooks stocks.
The other, and perhaps just as troublesome reason, is that banking profits will hurt. Till recently, they were able to enjoy very cheap sources of funds and lend at high-enough rates, and make a great spread. Add ample growth and very few recognized defaults, and it's easy to see why bank profits have been at a high. The interest rate hikes will make their cost of borrowing higher; and when they raise lending rates they will have to deal with the problem of a slowing economy and therefore, potentially greater defaults.
In this policy, the RBI has also increased the provisioning requirements for loans gone bad — banks are expected to set aside some of the loan amount as a provision when the borrower doesn't repay, or if the banks restructure the loan. The provision percentages have now been increased, and this will hurt a number of banks who have lived on the edge of the lower provisioning requirements earlier.
Finally, RBI has raised savings bank rate to 4% from 3.5%. That means the amount that lies idle in your SB account will get 0.5% greater interest. This may not be significant for you, but for a banking system that has Rs. 10 lakh crore (Rs. 10 trillion) in SB accounts, this could mean Rs. 5000 crores in additional interest paid out over the year. For banks with a high savings account ratio to total deposits, the additional interest is likely to hurt margins.
Banks and financial companies form a significant part of the stock market indexes - 25% of the Nifty. A number of other companies have a strong connection with interest rates — since most automobiles are bought using loans, higher rates means that auto growth will hurt nearly immediately. Real estate companies have taken huge loans, and are even dependent on their customers getting loans to buy houses. Plus, they are one of the sectors that have heavily restructured loans — they're hurt by both the interest rate hike and the higher provisioning requirements (indirectly). At the middle end, companies will hurt from a lower demand — with the possible exceptions being "defensives" like Pharma and FMCG, because even when growth is slow you need toothpaste and medicines.
But why now? Rates have been going up for a while now, so why the delayed reaction? Our transmission policy is slow — our overall cost of funds takes a long time to react after the RBI takes action. A train will transmit speed changes to its bogeys near instantly, but a car hitched to a tow truck by a rope, much slower. The effect of using interest rates more harshly will result in slowing the economy, but like in other rope-like transmissions, there is bound to be more damage.
And stock prices were overstretched. With Price-to-Earnings (P/E) of over 20 our market was not inexpensive; stock prices needed to correct because they had gone too far. Most of India's IT stocks are selling, even after this drop, at a P/E higher than Apple — and are growing at less than a tenth of its pace. Our banks are some of the most expensive in the world, and we tend to give very high valuations to stocks that have produced, at best, moderate earnings growth. A reality check was due, even if the RBI forced our hand.
With the rate hike, what matters immediately to you and me is that our loan EMIs are going up, and we will get higher rates for our fixed deposits. But as growth slows, our lives will see a larger impact — from lesser traffic (yippee!) to lower stock prices (uh oh) to unemployment (no way!). But it's a better deal than too much inflation, and it seems that now the RBI also agrees.