India’s stock market has experienced a notable decline, with an 8% drop from its peak in late September. This downturn has prompted concerns among investors, particularly foreign institutional investors who withdrew ₹94,017 crore (approximately $11.2 billion) in October. As the outlook for corporate earnings dims, calls for the Reserve Bank of India (RBI) to reduce the repo rate have intensified, denoting the delicate balance between controlling inflation and stimulating economic growth.
About Repo Rate and Its Significance
The repo rate is the interest rate at which the RBI lends money to commercial banks. A reduction in the repo rate typically leads to lower borrowing costs for banks, which can encourage lending to consumers and businesses. This mechanism is intended to stimulate spending and investment, thereby encouraging economic growth. However, the RBI is cautious about making such cuts, particularly in the context of rising inflation.
Inflation Trends and RBI’s Strategy
Inflation, as measured by the Consumer Price Index (CPI), stood at 5.5% in September 2024, largely driven by food prices, which have an important weightage in the CPI. The RBI’s mandate includes controlling inflation, and while it can influence non-food inflation through interest rates, it has limited control over food prices. The core inflation rate, which excludes volatile food and fuel prices, averaged 3.5% in 2024-25, indicating that the RBI’s policies have been somewhat effective in managing overall inflation.
Impact of High Interest Rates on Banking
Maintaining high interest rates serves to discourage excessive lending by banks, thereby controlling the creation of new money. This is crucial in preventing inflation from escalating. Contrary to popular belief, loans create deposits; thus, when banks lend, they effectively increase the money supply. By keeping interest rates elevated, the RBI aims to limit the amount of money circulating in the economy, which helps to stabilise prices.
Changes in Household Investment Behaviour
The pandemic has transformed the investment landscape for Indian households, leading to a higher proportion of investments in stocks rather than traditional savings accounts. This shift has altered the composition of bank deposits, with households now holding a smaller percentage of long-term deposits. A reduction in the repo rate could exacerbate this trend, leading to a further imbalance in banks’ asset-liability structures.
Future Prospects and RBI’s Position
As stock prices continue to decline, there is a possibility that households may shift their investment strategies away from equities. If this trend persists, it could provide the RBI with the leeway to decrease the repo rate without worsening the asset-liability mismatch for banks. However, the RBI’s current focus remains on aligning inflation with its target of 4%, a commitment that may influence its policy decisions in the near future.
Questions for UPSC:
- Discuss the role of the repo rate in India’s monetary policy.
- Analyse the impact of inflation on the Indian economy and RBI’s strategies to control it.
- Evaluate the changes in household investment patterns post-pandemic and their implications for the banking sector.
- What are the potential consequences of a declining stock market on the broader economy?
- Examine the relationship between interest rates, lending behaviour, and inflation control.
