Did the stock market over-react to the 50 bps CRR cut by RBI?

The short answer to the question is: Yes. The CRR rate cut is good news, but not great news. Great news would have been a cut in the repo and reverse repo rates. Now, the long answer.

Imagine that you are a farmer in central India, and it is the middle of April. With poor access to irrigation facilities, your crop is dependent on the monsoon rains. Your cousin from the nearby town comes to visit you and mentions that it was announced on the TV that monsoon may set in a week early in the middle of June instead of the third week. No doubt, that would be good news. But the rains will still be two months away.

RBI's announcement is somewhat similar. The CRR rate cut is an indication that repo and reverse repo rates may be reduced two months down the road. So, today's high volumes may be a sign of a buying climax.

What is the CRR and what purpose will be achieved by cutting it from 6% to 5.5%? Cash Reserve Ratio (CRR) is a percentage of the total deposits in a bank that has to be maintained as a 'reserve' with the RBI. It is one of the monetary instruments used by the central bank to regulate the money supply in the financial system.

Due to the aggressive interest rate increases by the RBI to contain inflation, growth has started to slow down. In fact, the RBI has now set the GDP growth target for 2011-12 at 7% - down from earlier revised target of 7.6%. Much lower than the glory days of 9-10%. India Inc. have been complaining that growth was being sacrificed to control inflation. Now that inflation rate has finally started to moderate, RBI has taken the first step by increasing the liquidity in the financial system.

How does it work? Let us say, a bank has Rs 10,000 Crores as deposits. A 6% CRR implies that Rs 600 Crores have to be maintained as a 'reserve' with RBI. That means, the bank has access to only Rs 9400 Crores that it can give out as loans. A 50 bps (i.e. 0.5%) cut in the CRR leaves the same bank with access to Rs 9430 Crores to deploy gainfully. On the extra Rs 30 Crores, the bank can expect to generate an additional Rs 3 Crores in profit.

The overall cash infusion into the banking system is expected to be about Rs 32,000 Crores, which can be loaned out to generate a profit of say Rs 3200 Crores. Not a small sum, but not a king's ransom either. Now you know why the bank stocks rose today. But that is the theoretical view point. What is likely to happen in real life?

Is India Inc. going to break down the doors of banks to apply for loans? Highly unlikely. Remember that the interest rates remain just as high as it was two months back, when no one was taking loans and were postponing capital expenditure. Banks are also struggling to contain their NPAs and have become quite rigid in doing due diligence before handing out loans. Add to that the likelihood of the inflation fires getting stoked by the excess liquidity in the system. There is also 'hidden' inflation due to large subsidies.

All in all, definitely not a cause for celebration. The RBI governor clearly put the ball in the government's court by pointing out that fiscal profligacy is one of the major causes of inflation. Unless core inflation falls further, do not expect a cut in the repo or reverse repo rates in a hurry.

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RBI pauses interest rate hikes – why did the stock market dive?

Stock markets and interest rates have a love-hate relationship. Markets love low interest rates, but detest high interest rates. ‘Low’ and ‘high’ are relative terms. As a very rough thumb rule, a Repo rate of 5% or lower can be taken as a ‘low’ rate; 7% or higher can be considered a ‘high’ rate.

In Jul ‘08, the Repo rate (the interest rate payable by commercial banks when they borrow money from the RBI) had peaked at 9% – more than 6 months into the previous bear market that lasted from Jan ‘08 to Mar ‘09. Thereafter, Repo rates and Reverse Repo rates (interest rates payable by RBI when they borrow money from commercial banks) were gradually reduced till the Repo rate hit a low of 4.75% in Apr ‘09.

By Mar ‘09, when the Repo rate was at 5%, the stock market reversed direction and started rising. The ‘lag’ effect of interest rate changes are evident from the above data. Bear markets start well before interest rates hit their peak; bull markets start before interest rates drop to the bottom.

The next increase in the Repo rate came only in Mar ‘10, when it was raised from 4.75% to 5%. The bull market was already a year old by then. Thereafter, 12 more rate increases – the last of them in Oct ‘11 – took the Repo rate to a high of 8.5%. By then, the bear market from the top of Nov ‘10 was almost a year old.

Why do stock markets hate high interest rates? Because the cost of doing business increases for every one, and profits take a hit. Capital expenditure is postponed, which hurts growth and in turn, hurts profits. When earnings decrease, EPS reduces. P/E ratios become higher, which induces selling of stocks and shifting of investments to bank fixed deposits at high rates.

Two months back, RBI last increased the Repo and the Reverse Repo rates by 25 basis points (0.25%). The stock market had expected the hike, but appeared to celebrate the news by moving up. That seemed to go against logic. Stock markets are supposed to hate high interest rates. What may have caused the celebration was a hint by the RBI that they may not raise rates further if inflation rate started to moderate.

Inflation rate has started to drop, though it continues to remain high. Food inflation has fallen quite remarkably – whether due to seasonal reasons or high ‘base effect’ or both. The high interest rates caused GDP growth to slow down and de-growth in IIP (Index of Industrial Production). So, it was no surprise that RBI left the interest rates unchanged, and hinted that rates may be lowered henceforth to spur growth. Instead of celebrating, the stock market dived – again appearing to defy logic.

What happened? Many market players had expected a cut in the CRR (Cash Reserve ratio – the percentage of total deposits that commercial banks have to maintain in cash) to inject more liquidity into the financial system. But a combination of an inflation rate that is still high and a fast depreciating Rupee against the US dollar may have forced RBI’s hand in keeping the CRR in tact. That perhaps caused disappointment that led to the sell-off today.

During a bear market, the slightest bit of ‘bad’ news causes a disproportionate amount of negative sentiment. Even if the news isn’t bad for the long-term but appears to be bad in the short-term gives a good enough reason to sell. The opposite happens in bull markets, when the slightest bit of ‘good’ news sends the stock indices soaring. That is an unlikely occurrence at least for another 6 months. Till interest rates are reduced significantly, the bulls will not return.

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Market celebrates RBI interest rate hike – why?

Market celebrates RBI interest rate hike – why?

RBI increased the repo rate (at which it provides short-duration loans to banks) and the reverse repo rate (at which banks maintain short-duration deposits with the RBI) by 25 basis points each. The repo rate is now 8.5% and the reverse repo rate is now 7.5%. The CRR has been left unchanged at 6%.

With inflation remaining stubbornly high despite 12 rounds of rate increases since Mar 2010, it was widely expected that the RBI will increase the repo and reverse repo rates by 25 bps (0.25%) today. The market should have already discounted the rate hike. Why the buying celebration then? Was there some good news that the market liked?

Apparently, there were three. First, and most important, the RBI governor hinted at inflation rate moderating to 7% by Dec ‘11, in which case there will be no further rate hike at the end of the year. Moderation of inflation and a likely pause in the rate hike cycle was considered ‘good news’ by the market.

Also, for the first time ever, interest rate on savings bank accounts have been de-regulated. That means banks have the freedom to offer any interest rate on savings bank accounts that they deem fit. Last, but not the least, banks have been given the freedom to open branches in Tier-II through Tier-VI towns without prior permission.

Let us look a little more critically at each of these pieces of ‘good news’.

How will inflation suddenly moderate to 7% in less than 2 months when it has remained uncontrollably high for the past 20 months? Will food prices suddenly fall? Will government employees get less salary? Will politicians become honest and stop their looting? The answer is: none of the above.

The moderation will happen due to the ‘base effect’. Inflation was already high in Dec ‘10. So the YoY increase in Dec ‘11 will appear to be less. Actual prices that we pay will remain almost the same as now. There is also a possibility that diesel and kerosene prices will finally be increased if inflation does moderate. So, we may get back to square one.

What about the pause in the rate hike? Well, that won’t help much either. Better than bad isn’t necessarily good. As per RBI’s guidance, the GDP growth rate has been revised down from 8% to 7.6% in year ending Mar 2012. There are already signs of growth slowdown, which will be exacerbated by today’s rate hike. Unless interest rates start heading downwards, stock markets are unlikely to go up.

Is the saving bank interest rate de-regulation good news? Certainly not for banks. Their business has already been hampered by high interest rates – due to which loans have become dearer and term deposit rates have gone up. If interest rate on savings bank accounts is increased, it will be a direct hit on bank bottom lines.

As per the Economic Times, if savings bank interest rate is increased from the current 4% to 5%, then all the banks put together may need to pay out an additional interest of Rs 15,000 Crores, which may reduce the entire banking sector’s profitability by 13%.

Look at it another way. Savings bank account holders will collectively receive an extra Rs 15,000 Crores. What will they do with the sudden inflow? Why, spend most of it. Will that stoke the fires of inflation or not? You tell me!

SBI has the largest percentage of savings bank accounts among all banks (Yes Bank has the fewest) and will be affected the most by an increase in savings bank interest rate. The CMD went on record that SBI will not increase the savings bank interest rate. He also said that de-regulation means rates can also be reduced.

What about opening branches in small towns? It may help in financial inclusion of people living in remote areas where no bank branches exist. But if there was a lot of business potential in Tier-II through Tier-VI towns, banks would have sought permission to open branches there by now. By removing the red-tape of prior permission, the business potential of remote corners of the country is not going to increase overnight. But opening branches will add to the operating costs of banks.

The ‘good news’ doesn’t seem so good, does it? What was the reason for the buying today? It was a combination of short-covering and index management – today being early F&O ‘expiry day’ because of the Diwali holiday. The broader markets didn’t participate much in the rally.

Both the Nifty and the Sensex are poised at the upper end of their respective trading ranges of the past 11 weeks – with the huge gaps caused in Aug ‘11 remaining unfilled. Tread with caution.

Is the interest rate increase by RBI good or bad for investors?

Increasing interest rates are great for older investors and retirees. Their loans have mostly been paid off. They rely more on stable fixed income instruments, and higher interest rates are always welcome even if it isn't enough to cover inflation.

For younger investors, who can afford to take more risk and invest in the stock market or mutual funds, higher interest rate is bad news. Why? Because stock markets and rising interest rates are inversely proportional. Many market players use loans and margin money to invest. Their costs increase and make their leveraged investments unviable. Companies have to pay more interest, which affect their profits. They tend to hold back on capital expenditure, which affects growth.

As growth starts to slow down, the investment environment changes from bullish to bearish. Investors start to book profits, and move to safer havens like bank fixed deposits and gold.  The Sensex starts sliding which leads to more selling. It has a spiralling effect.

Doesn't the RBI know all this? Why are they increasing the repo and reverse repo rates again and again? Don't they know that growth is getting stifled?  The short answer is: they know what they are doing. But the RBI is caught between the devil and the deep blue sea. With inflation threatening to go out of control, increasing interest rates is the only tool they have - even if it causes a short-term growth slow down.

Unfortunately, the government is not playing its part. Bold policy changes are the need of the hour - FDI in multi-product retail, industry-friendly labour policies, unified tax regime are some of them. But such policies may upset the apple-cart - the nexus between politicians and their crony middlemen. The greater good is being sacrificed so a few people can get incredibly rich. Cutting out the middlemen will immediately put a tight leash on inflation. Interest rates can then be lowered and the economy will get back on the growth path. But that seems like wishful thinking.

What are the likely next steps? For the RBI, probably more rate hikes till the base effect kicks in and the inflation rate starts to moderate. For young investors, the stock market is unlikely to make new highs any time soon; so a good time to read up and, hone stock-picking skills. Lower levels of the Sensex may provide good opportunities to enter. For older investors and retirees, enjoy the high interest regime while it lasts.

RBI tries a ‘shock and awe’ tactic to tame inflation

In what seems like a last-ditch effort to bring inflation under control, the RBI decided to use a ‘shock and awe’ tactic – even if it meant a slow down in growth in the near term – by raising the repo and reverse repo rates by 50 bps (i.e. 0.5%) each.

That may not seem like much, except that the consensus estimate in the market was a 25 bps hike. Some even hoped for a pause in the rate hike, as there were some signs of slow down in inflation and growth. The 50 bps increase came as a bolt from the blue, and the bears didn’t waste a moment in extracting a heavy toll.

Wikipedia describes the ‘shock and awe’ tactic as follows:

‘Shock and awe (or rapid dominance) is a military doctrine based on the use of overwhelming power, dominant battlefield awareness, dominant maneuvers, and spectacular displays of force to paralyze an adversary's perception of the battlefield and destroy its will to fight.’

Whether inflation will get tamed or not remains to be seen. But a 100 point drop in the Nifty and a 350 point fall in the Sensex may seriously hamper the bulls’ will to fight. However, the rate increase should not have come as a big surprise to readers of this blog. After the previous rate hike in June ‘11, this was my cautionary statement:

‘… without appropriate fiscal and policy measures to support the RBI's monetary tightening, inflation is not going to come down any time soon. … Which means more tightening and further increase in repo and reverse repo rates in future, while the governments 'addiction' remains uncured.’

I paid Rs 50 a kg for fresh ‘bhindi’ yesterday. People living in Mumbai and Delhi may laugh at such ‘cheap’ rates, but it is the maximum I have ever paid for a non-exotic vegetable in Kolkata. Now there is talk of allowing only 6 LPG cylinders per family per year at the ‘subsidised’ rate of Rs 405. Any additional cylinders will be billed at Rs 700 to mitigate under-recoveries of the oil marketing companies.

Even the current slightly moderated inflation rate – which the RBI is trying to bring down further with the 50 bps rate hike – is actually an artificially lower rate due to subsidised prices of diesel, kerosene and LPG. The actual rate is way higher.

So, be prepared for more rate hikes, more EMI payments, slower growth in the economy and a sliding stock market. The press conference of bank CEOs following the RBI announcement made one thing crystal clear. Things will get a little worse, before they get any better.

But there is a silver lining to every dark cloud. Shorter-term fixed deposit rates are likely to be raised soon. Time to take some profits off the table, and reallocate to fixed income. Looks like a very testing time for the bulls till Diwali.

RBI raises repo and reverse repo rates - again

Most economists and stock market analysts were expecting RBI to raise the repo and reverse repo rates by 25 basis points (i.e. 0.25%). So, the markets should have already 'discounted' the interest rate hike. Then why did the Sensex drop nearly 150 points to slip below the psychological level of 18000?

Before I attempt to answer that question, a little digression.

Many Indian working/earning men have different types of addictions. Some are addicted to tobacco. Some like to go to the races. Others like to hit the bottle. All such addictions cost money. And that money comes off from the top - i.e. before the monthly expenses are incurred.

In other words, to feed the addiction, needed monthly expenses have to be curtailed. Which doesn't make sense to any one - except the addicted person. Month in and month out, he blows money up in smoke (or in torn race tickets, or in drunken stupors), while bills remain unpaid. And then, money has to be borrowed to pay the bills - making a bad situation worse.

The RBI is facing a similar predicament. Time and again, they have raised the repo and reverse repo rates in a graduated bid to curtail inflation without hampering growth. Without much success. In fact, inflation rate has started climbing again. Why? 

The global downturn followed by the massive money printing (better known as Quantitative Easing - Part 1 & 2) 'exported' inflation to the developing countries like India, by buying up stocks in better performing markets. The Indian government has continued with wasteful expenditure - better known as 'subsidies' - which inevitably doesn't benefit ordinary citizens. 
 
Vote bank politics ensured that required financial reforms and tough fiscal policies were avoided (or at best, not pushed through). Prices of diesel and kerosene have not been increased with the excuse that inflation will climb even higher. Nor have the punitive taxes on petroleum products been reduced, which could have partly mitigated the price hike.

Lot  of sound bytes have been issued about curbing black money generation and bringing perpetrators to book. The fact of the matter is that the few arrests in the various scams have only come about due to prodding by the Supreme Court. The government departments and the ruling party remain the biggest sources of black money generation. 

No concrete improvements will happen in transparency and governance till the elected leaders reform themselves. All the talk about identifying account holders in Swiss banks has led to some of the black money getting re-routed through 'hawala' channels back into the country - further stoking the fires of inflation - and into real estate deals. Probably the reason why debt-burdened real estate companies are refusing to lower the prices of apartments and buildings.

And food inflation? That can be eliminated in one simple step - by allowing FDI in food retailing. All the apparent concern about 'kirana' stores going out of business is nothing but crocodile tears. There are too many middlemen with close ties to the one in Power (pun intended). The humongous wastage will be eliminated through modern refrigerated storage and transportation facilities. Removal of middlemen will be a win-win for farmers and consumers.

Sorry about that long rant. The point is, without appropriate fiscal and policy measures to support the RBI's monetary tightening, inflation is not going to come down any time soon. That is what came out of the RBI's statement today. Which means more tightening and further increase in repo and reverse repo rates in future, while the governments 'addiction' remains uncured.

That is why the Sensex dropped. 

RBI raises interest rates – markets crash; what should investors do?

Regular readers of this blog should not have been too surprised by today’s selling, which followed the RBI announcement raising the repo and reverse repo rates by 50 bps (0.5%) each. In last Saturday’s analysis of the Nifty chart, I had mentioned the possibility:

‘The markets have already discounted a likely 25 bps interest rate hike by the RBI next week. If the actual hike is 50 bps, there can be more selling.’

The RBI governor had adopted a graduated raising of interest rates so far, taking baby steps of 25 bps on the past few occasions. Market players had expected a similar hike this time around, but were taken aback by the aggressive stance of the RBI. So, they decided to head towards the ‘Exit’ doors.

What signal is the RBI trying to convey? Inflation has now become a bigger concern than growth. It needs to be contained, even if growth slows down in the near term. Is that the right thing to do? What happens over the next few months will provide the answer to that question. Interest rate hikes take some time to percolate through the financial system.

The fact is, the earlier rate hikes of 25 bps at a time - in an effort to balance inflation and growth - has not really worked. Inflation continues to remain high, though it has reduced from double digits to single digit. The unrest in the Middle East caused a spike in oil prices that made the inflation situation even worse.

Thanks to the elections in a few states, petrol prices have not been raised. But they surely will be, once elections are over. Diesel, kerosene and cooking gas subsidies are huge burdens being borne by the oil marketing companies. At some point, diesel prices will need to be de-controlled. That will further stoke inflation.

The RBI governor decided to bite the bullet and tackle inflation with a heavier hand now. Higher interest rates will hinder the already slowing credit off-take and capex plans of India Inc. GDP growth in FY12 is expected in the 7.5% – 8% range. Not bad, but lower than earlier forecasts. Profit margins of India Inc. will reduce. That is why the sell-off happened today.

What should small investors do? Some times the best thing to do is to do nothing (and enjoy the extra 0.5% interest in your savings bank account that RBI doled out). Wait for the dust to settle, and the selling to subside. Then pick up some of the better stocks that may have been beaten up badly, and whose valuations start to look attractive.

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