How RBI policy impacts interest rates

The Reserve Bank of India (RBI), which is India's central bank and the bank, is
one of the most important players in the Indian economy and financial markets. It
is in charge of monetary policy which has a big impact on liquidity and interest
rates in the financial system. Let's look at some of the basics of monetary policy
and how it impacts the average investor.
The RBI has several goals of which controlling inflation is one of the most
important. When inflation is rising and threatening to spin out of control, as it is
today, the RBI 'tightens' monetary policy which means reducing the amount of
liquidity (floating money) in the economy. Though the RBI's policies may take
upto a year to show their full effect they are perhaps the most effective way of
reducing inflation.
How the RBI conducts monetary policy
The RBI has several tools for conducting monetary policy: two of the most
important are the cash reserve ratio (CRR) and the liquidity adjustment facility
(LAF).
The CRR is the proportion of their deposits which banks have to keep with the
RBI. Raising the CRR is one of the most effective ways for the RBI to suck
liquidity out of the financial system which reduces demand in the economy and
therefore helps curb inflation. Thus recently the RBI raised the CRR from 7.5 per
cent to 8 per cent which sucked Rs 18,000 crores out of the banking system.

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The LAF can be thought of as a way for the RBI to lend and borrow to banks for
very short periods, typically just a day. The repo rate is the RBI's lending rate and
reverse repo rate is the RBI's borrowing rate. These two rates help the RBI
influence short-term interest rates in the rest of the financial system.
Currently the RBI has left the repo/reverse repo rates untouched but if inflationary
pressures remain strong it may be forced to increase them.
Impact on interest rates
What impact does monetary policy have on the different interest rates in the
economy like the home loan rate? The RBI doesn't directly control these interest
rates but in general a tighter monetary policy leads to higher interest rates.

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This relationship isn't iron-clad though, and major banks like SBI [ Get Quote ] and
ICICI [ Get Quote ] have stated the recent CRR hike wouldn't necessarily lead to
higher interest rates. However if the RBI continues to tighten policy further by
raising the CRR again or raising the repo/reverse repo rates, it's possible that banks
will respond by raising interest rates on various loans including home loans.
Impact on stock markets
If you watch investment channels or read business papers, you will know that the
financial markets pay obsessive attention to the actions of the RBI. This is with
good reason since any changes in monetary policy has an immediate impact on
financial markets.
In general a tighter policy will hurt investor sentiment and stock prices. There will
be less liquidity floating around and higher interest rates will raise the cost of
capital for companies hurting their bottom lines and stock prices. Companies
which have high levels of debt are especially vulnerable.
A tighter policy will harm some sectors like banking and real estate more than
others. For example banks don't earn interest on the reserves they keep with the
RBI; therefore an increase in the CRR immediately hurts their bottom line.
Similarly if tighter policy leads to higher interest rates, this will reduce demand for
housing as home loans become more expensive.
Impact on exchange rates
The RBI's monetary policy will also have an impact on exchange rates. In
particular if Indian interest rates rise because of tighter policy, the demand for
Indian interest-paying assets will also rise, leading to an increase in the value of the
rupee.

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This helps with inflation since imports will now be cheaper in rupee terms. For
example if the price of oil is $100 per barrel and the rupee rises in value from Rs
42 to Rs 38 per dollar, the rupee price of a barrel of oil will fall from Rs 4,200 to
Rs 3,800.
On the flip side, the  rising rupee will have a negative impact on export-oriented
companies; for example major IT stocks which have done quite well recently may
fall.