Indian Capital Market, Repo Rate and Inflation

-by Shabih Fatima, a 3rd Year B.A.LLB (Hons) student at Jamia Millia Islamia, New Delhi.

Key words: RBI, Foreign Investment, Financial Markets, Repo Rate, Inflation

Introduction

A well regulated financial market is what drives the working of any efficient economy. Any
country's economic development is fueled by a well-regulated financial industry. The world
is looking to emerging nations for a greater return on investment after liberalising economic
rules and globalizing the asset market. This anticipation of better returns encourages capital
flow into emerging financial markets, not just from foreign investments but also from
domestic investments

The present Indian Capital Market

The biggest pull-out of Foreign Portfolio Investors (FPIs) of Rs. 201, 500 crores (As on May
30th, 2022) is a major negative hit in the history of Indian Capital Market. In India, the
reasons for FPIs pull-out can be related to the increased tax surcharge. The implementation
of buyback tax is also seen to be a driver for this exit. However, predominantly, this began
since October 2021 as a result of global inflation. Accelerated by the Russia-Ukraine
conflict, rising bond yields in the US, apprehension of recession in the US, an appreciating
dollar, aggressive sudden tightening of the monetary policies, relatively high prices in India,
and a whopping hike in global commodity prices, particularly crude oil are factors behind
FPIs pull out. The FPI inflows cause stock market indices to rise, while their outflow causes
market indices to fall.. Thus, the selling of FPIs brings about large changes in the market by
resulting in an increase in the volatility. Volatility is one of the most crucial factors in
investment decisions. It is defined as a degree of price variation during a particular period.
Along with the FPIs, the Domestic Institutional Investors (DIIs) also play a key role in the
monopoly of the market. Banks, Insurance companies and mutual funds are some of the DIIs
which mobilize funds into the Capital Market. If the FPIs react aggressively by selling out
then DIIs can bring the volatility down and stabilize the market. The recent rigorous selling
by the FPIs was offset by the buying from DIIs who have tremendously increased their
holding in 72 percent of Nifty50 companies. The study of influence of FPIs and DIIs in the
domestic market is of great importance from the perspective of policymaker for monitoring
of systemic risk for India in particular and other markets of countries in general.

The big worry: Inflation

The major economies of the world like US and the Europe are presently witnessing
continuous rise in inflation, as a result of which, the central banks have started tightening the
monetary policies and hiking the interest rates. The US Consumer Price Index (CPI) inflation
is recorded to be at around 8.3 % in April and that of the Europe, the annual inflation reached
8.1 %. In the recent data released by the National Statistical Office, retail inflation in India as
measured by Consumer Price Index rose to an eight year high of 7.8 percent. With this
increase in inflation in global economy, a sharp sell-off in financial markets has been
witnessed across worldwide.

RBI’s fight with Inflation

Section 45-ZA of RBI Act, 1934 stipulates that with the consultation pf the Reserve Bank of
India, the Central Government shall determine the inflation target in terms of Consumer Price
Index (CPI), once in every five years. Accordingly, in a notification on March 31, 2021, the
Central Government, in consultation with the RBI, retained the inflation target at 4% (with
upper tolerance level of 6 per cent and the lower tolerance level of 2 per cent) for five year
period April1. 2021 to March 31, 2026. Entering the sixth straight month where the inflation
has come in above the upper threshold of RBI’s inflation targeting framework, clearly signals
the failure of central bank’s fall behind the curve when it comes to managing inflation.In its
monthly meeting on June 8th,, the RBI raised the repo rate by 40 basis points to 4.90%.
Moreover, The RBI has been giving further signals of an increase in the repo rate in the next
quarter. Repo rate is the rate at which RBI lends money to the commercial banks. As a move
to cool the inflation, the central bank increases the repo rate acting as a disincentive for
commercial banks and making borrowing for them stricter. This leads to controlling the
money supply in the economy, thereby clenching the inflation. Inflation is majorly being
driven in the present time by global food and commodity prices.

How can high repo rate slow down Inflation?

Firstly, high repo rate lowers the expectations of future inflation. This can be done by
alleviating the current inflation further by pushing the demand. This would not be feasible for
the market of India. However, it can be done efficiently in the developed and emerging
markets. Secondly, higher interest rates attracts foreign capital which helps in appreciating
the currency, which is again not the case for the present market in India as the rupee is
touching new levels of depreciation each day. For this to work in India, it would require
massive rate hikes, given the regulations by US Fed. Thirdly, the most appropriate outcome
can be achieved by curbing the credit growth which can be done by raising the cost of
borrowing as well as its availability. The question still stands rigid because of the small real
credit growth which is running around 2 % presently in India.

The relationship between Repo Rates and Stock Market and its impact on DIIs
Investment

There is an adverse relationship between repo rates and stock market. With every change in
the repo rate made by the RBI, an impact on stock markets is established. A cut in the interest
rate makes the inflow of cash in the market prominent, whereas, a hike in the repo rate makes
the companies and DIIs cut their spending on expansion and thus this curbs the growth of the
market as it affects the cash inflow and thus the prices of the stocks fall. Therefore, the rise in
repo rate leads to reduction in the flow of capital to the economy. Being a prominent player
in the domestic market, the DIIs investment have surged during the FPIs exit but the question
arises until when can these Institutional investors control the growth of the market given the
restriction arising in their expansion of investment.

Food for thought

Since the present economic condition desperately awaits the further rise in repo rate, the
exponential exit of the FPIs from the Indian Stock Market is also something which cannot be
overlooked. As increase in repo rates results in more saving and less spending therefore
resulting in the lower cash inflow in the economy, the situation now arises that the RBI’s
move to increase the repo rate further with an intend to fight inflation might also bring the
economy’s growth to a stall. A mid-way should be sought by the policy-makers to bring the
country back with the market capitalization of $2 trillion as well as keep the inflation under
the prescribed level.