In India, the Reserve Bank of India (RBI) is responsible for setting the target interest rate at which banks can borrow and lend money to one another. Any changes to these interest rates can have a ripple effect across the county’s economy. In this article, we will let you know what happens when interest rates are increased by the Reserve Bank Of India (RBI) and How it impacts our economy.
The Reserve Bank of India’s (RBI) mission is to keep the country’s inflation rate within the tolerance band as fixed for the period April 1, 2021 to March 31, 2026. The inflation target in terms of the Consumer Price Index (CPI) as notified by the Central Government in the Official Gazette, in consultation with the RBI, is 4%, with the upper tolerance limit of 6 percent and the lower tolerance limit of 2 per cent.
When inflation is above the upper tolerance limit, RBI steps in and raises interest rates, which helps to cool down the inflation by decreasing money supply to keep the growth on track.
Increasing or decreasing interest rates is a part of RBI’s monetary policy for the country, which is considered as job number one for the Reserve Bank of India. It controls the supply of money in India’s economy.
When people talk about the RBI raising interest rates, they are basically referring to the repo and reverse repo rate.
Repo Rate is the interest rate at which the Reserve Bank of India provides money to all commercial banks and financial institutions such as ICICI Bank, HDFC Bank, Axis Bank, Kotak Mahindra Bank, SBI, Union Bank, and others.
Repo rate stands for ‘repurchasing option or repurchase agreement’.
Reverse Repo Rate is the interest rate at which the Reserve Bank of India absorbs liquidity from banks.
What is the impact on EMIs and the economy when RBI raises interest rates?
When RBI raises the interest rates, the main purpose is to increase the cost of credit through the economy. The repo rate hike means higher EMIs for new loans and extended tenures for existing floating rate loans. With the increase in interest rates, borrowing becomes more expensive for both businesses and consumers. Due to such an increase everyone starts spending more on interest payments.
Businesses or individuals who can’t afford such high interest rates, prefer to postpone their projects that involve financing. It also encourages people to save money to earn higher interest payments. This reduces supply of money in circulation, which in term reduces economic activity of the country, resulting in lower inflation due to less production and less buying of goods and services that involve financing.
For instance let us assume an individual is planning to buy a house property by availing a home loan from a leading bank in India. At present assume that the bank is offering 9.5% interest per year on Home loans. Now RBI increases the interest rate by 0.5%, due to which home loan interest rate is increased to 10% per year. Due to increase in interest rates, the individual might delay purchasing a home. This decreases the demand for home buying and reduces the cost.
In this way rising interest rates impact credit cards, personal loans, education loans, auto loans and business loans EMIs.
Due to high interest rates if you can not afford the present EMI, then you may explore the option of tenure extension with the lender.
Rise in interest rates makes borrowing money from a bank not so attractive. This slows down the investment and supply of money in the market. Low purchasing power will lead to slow demand and control on inflation.
When RBI increases the repo rate, banks generally follow it by hiking their lending interest rate on almost all loans such as housing loan, auto loan, personal and business loan.
If the cost of funds for banks or lenders increases, then they have two choices: either to pass on the higher cost to the borrower or to absorb it. If banks instead of passing on decided to absorb, then its profitability will go down.
If RBI indicates continuation in hike of interest rate, then your lender may decide to pass on the hike for you.
When a bank increases the interest rate, the equated monthly installments (EMI) automatically goes up, impacting the borrower’s pocket.
However depositors who have parket their money in bank savings accounts, fixed deposits are going to get more due to equat rate hike in deposit interest rates.
How does rising interest rates impact the stock market?
Changes in interest rate can have both positive and negative impact on the markets. In general, when an increase in interest rates is higher than the market expectation, then it can have a negative impact on the stock market.
When RBI hikes interest rates, borrowing becomes more expensive, therefore cost of funding for corporate india increases. Higher costs and less business means lower revenues and earnings, due to which stock price might come down.
If the market expects more hikes in interest rates, then investors might move to defensive stocks by selling their stake in existing high debt stocks.
Sectors which are highly capital intensive, capital goods, real estate and infrastructure get mostly affected due to interest rate hike. These companies require substantial capital to grow. High debt to the balance sheet of these companies brings more finance cost affecting profitability.
Whereas for FMCG and the non-discretionary product sectors, it’s easy to pass on the rise of raw material prices and finance costs, if any. They not only raise the price but also manage the pack size to reduce cost to remain profitable.
How does it impact saving and deposits?
When the RBI increases the interest rates, you get more on your savings and deposits. This means the interest rate on your savings, recurring deposits and fixed deposits also increases.
Basically RBI by increasing interest rates encourages people to invest in fixed deposits and bonds.
Increase in interest rates will lower the value of existing bonds as market participants will be interested in buying new bonds offering higher interest rates as per the present market situation.
As financial advisors suggest the best way to handle inflation is to have a diversified portfolio with the right asset allocation among stocks, bonds and cash.
Disclaimer: In addition to the disclaimer below, please note, this article is not intended to provide investing or trading advice. This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Trading in the stock market and in other securities entails varying degrees of risk, and can result in loss of capital. Most investors and traders lose money. Readers seeking to engage in trading and/or investing should seek out extensive education on the topic and help of professionals.
