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  • Writer's pictureSahastha

Monetary Policy – How it helps for Healthy Economy?

Updated: Oct 4, 2023

Monetary policy is a tool with which the RBI controls liquidity by controlling the interest rates. It mainly concentrated on the management of money flow and interest rate to regulate macroeconomic objectives like inflation, consumption, growth and liquidity. The RBI maintains the interest rates to strike a balance between growth and inflation. If the interest rates are high, that means the borrowing rates are high for companies, which impacts sales, earnings, expansion, employment etc. On the other hand, when the interest rates are low, Easy availability of credit at low interest rates stimulates investment and improves economic growth. But more liquidity in the market will affect consumer spending capabilities which increases prices, it will cause inflation.

Current Status

RBI keeps maintaining the repo rate at 4% since April, 2019. It is mainly due to Inflation concerns, reducing uncertainty in economic growth. In march 2021 CPI inflation rises to 5.52%, there is some uncertainty in rising inflation levels due to multiple factors such as rising fuel prices, Covid infections, etc. RBI expects to maintain CPI at 5.1%, growth at 9.5% during FY 2021-22, also targeting rescue operations for the sectors which are adversely affected. To push credit and liquidity to the stressed areas of the economy, RBI announced G- SAP program. Government Securities Acquisition Program (GSAP 1.0) which will purchase government securities worth₹ 1 lakh crore in Q1FY22 to support the bond market. In this month, RBI will purchase₹ 40,000 crore of government securities, comprising state development loans worth ₹10,000 crores under the ongoing G-SAP 1.0, additionally G-SAP 2.0 of ₹1.2 lakh crore will be conducted in the second quarter. This will help to hold yields low and control excessive volatility faced by market participants in the government securities market.

To support the sectors which are unstable with the burden of second wave of the pandemic, a separate liquidity window of ₹15,000 crores is being opened till March 31, 2022 with tenors of up to three years at the repo rate. Under the scheme, banks can provide fresh lending support to hotels and restaurants, tourism, aviation ancillary and some other sectors.

How market will react in changing interest rates

As we can see, a change in the interest rate and liquidity of the cash can directly or indirectly affect the debt and equity market.

Inflation sends many people below the poverty line, this lowers consumption spending and investment spending.

Inflation makes exports costlier and attracts imports to a large extent. It leads to adverse effects on the balance of payments. This will put pressure on the rupee value.

When the interest rates go up, FPIs and FIIs find debt market more attractive in relation equity. This leads to capital outflows from equities and inflows into debt.

Fundamental factor between interest rates and equities is, when interest rates go up, it is a signal that corporates will have to pay a higher interest cost. As debt servicing cost goes higher, the risk of bankruptcy and default also increases and majorly this will impact small and highly leveraged companies.

Story of rate sensitivity

Due to hardening of yields since 2020, investors were concerned with regard to their existing or fresh investments in the bond market. Basically, interest rate is directly proportional to the yield and inversely proportional to the bond price. For example, assume that a bond was issued at face value of ₹100 at 8% interest rate. This implies the yield in this bond is ₹8. If the interest rate increases, it will bring down the demand of the 8% bond. So, the bond price also decreases to some extent (let’s say RS.85). People who buy the old one at discount value (82) will get a higher yield of 9.4 % (8%/ 85) compared to the original coupon rate (8%). On the other hand, when interest rates fall, new bonds with lower yields are less attractive than old bonds in the market, and investors are less likely to purchase new issues. It will increase old bond prices. Holding long term bonds are subject to a greater degree of interest rate risk than shorter term bonds. Interest rate risk is often not a big deal for those holding bonds until maturity. but when we want to sell those bonds before maturity, we face with a deeply discounted market price

Also, interest rates represent the opportunity cost of investing in equities. For example, if the 10years bond is yielding 6% per annum then the equity markets will be attractive only if it can earn well above 9% (assume a risk premium is 3% for equity investors). As interest rates go up the opportunity cost of investing in equities goes up and therefore equities become less attractive. Lower interest rates strengthen stocks valuations.

Conclusion

India is still dealing with pandemic, this covid crisis continuously hitting the stability in economy. In addition to G-SAP, RBI conducting regular operations under the setting up repo/reverse repo rates, forex operations and open market operations, including special OMOs, to manage liquidity and stability in the market. During the current year so far, the Reserve Bank has undertaken regular OMOs and injected additional liquidity to the tune of ₹36,545 crores, in addition to ₹60,000 crores under G-SAP 1.0. In this current situation the more liquidity in the market has adverse effect on inflation. Right now, controlling inflation is a main concern, there is sticky core inflation in this pandemic, rising fuel prices and commodity prices etc. It’s required to relook at its inflation forecast for coming months, need revise the process of liquidity normalisation.

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