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The saga of Interest rates in Stock Markets

We’ve established that the stock market plays a quintessential role in the financial sector of any economy, especially with developing countries.

As a way to control the market forces of demand and supply, the Reserve Bank of India uses a variety of instruments to help shape the narrative to its favor. Especially over the last few months, in an attempt to bolster investor confidence, the RBI has been particularly active in tinkering with interest rates and other ratios to infuse more cash circulation in the economy.

In India, interest rates are particularly rigid due to the fact of high public debt, a large number of non-performing assets, and the continuous policy of the RBI to accumulate foreign exchange reserves. However, with the cogs of the stock market grinding to a halt and the pessimism in the air leading to a stagnation of any form of business activity, it’s imperative to use the power of interest rates to it’s fullest.

A general rule of thumb is when the central bank cuts interest rates, it causes the stock market to go up; when the interest rates are raised it causes the stock market to go down.

The RBI has reduced all the rates in its immediate power:

- Cash Reserve Ratio is a ratio of funds that have to be kept by different commercial banks as a safety net. This has been reduced by a record low of 3%, thereby enabling more funds to be freed in the economy.

- Statutory Liquidity Ratio is a ratio that the center requires the commercial banks to maintain as quick liquidity. Up until a few months, it was required to keep 90% of the 4% of funds for this, but now the RBI allows the commercial banks to only keep 80%, thereby allowing more infusion of cash into the market.

- The RBI has cut the interest rates by 75 points while they have reduced the interest rate, they charge for lending to only 4.4%, which will again incentivize banks to give out more loans and be at relative ease to borrow from the RBI because of the low-interest rates.

As we’ve seen over the last few months, there have been significant gains and trading that have happened in the stock market, even with the country reeling from a lockdown of 3 weeks, and all forms of activity coming to a halt. With the above-mentioned relaxations, investors and businesses have shifted into overdrive to make full benefit of them. This helps a country to get back onto its feet, and invariably benefits the market participants and the companies through the availability of funds to invest and listing of competitive share prices to combat the demand.

Interest rates are a double-edged knife that can be used to create a shortfall of cash or create a surplus of cash, depending on a country’s current monetary policy. With the pandemic ranging and causing anguish and thereby people parking their disposable income into bank deposits, there is a shortfall in cash and very less liquidity. This is problematic because there is no flow of funds in the economy and this brings business activities to a standstill.

Negative interest rates became notorious during the tenure of the previous Japan Prime Minister Shinzo Abe, under his policy of Abenomics – primarily aimed at creating more activity and making the Japan market robust again. The banks in Japan were charged rates for holding the deposits they received from the consumers with the central bank. This encouraged banks to give out more loans that help consumer and business spending.

This resulted in the folks of Japan drawing out their investments and looking at different ways to invest their money – most notably in the stock market.

This policy was also used by the European Central Bank to combat the slow down in the EU countries reeling from the after-effects of the financial crises of 2008.

Negative interest rates not only help in garnering traction for investments in the stock market but also for short term instruments issued by the government, pushing up the prices but lowering the yield; Overall, this breathes life into a market that is starting to rust and decay.

In the short term, yes negative interest rates are definitely a way to go. It definitely helps rekindle the flames of a dying fire, by incentivizing both business and retail investors to be active in deploying out their funds and using it for different investment that would benefit themselves and the economy as a whole. But if not properly looked after, it can have an adverse effect.

It is a temporary panacea that is not a means to an end. Invariably there has been a certain stagnation the government will need in order to control inflation. Negative interest rates would counter that, therefore the government should be vigilant and observant to modify its monetary policy accordingly.

Written by Rohann

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