RBIs MONETARY POLICY AND STOCK MARKET PERFORMANCE Dr. K.

Sreenivas*
Besides, Union Budget, the RBIs monetary and credit policy pursues economic growth with price stability which refers to inflation control. Credit policy aims at credit delivery system to Industry and Agricultural development. The flow of credit to these sectors depends on cost of credit and availability of adequate funds. The factors like interest rate, margin money requirement, resources position, purpose of utilization of credit , general economic conditions etc., affect the credit delivery system. Declared semi-annually, the monetary policy takes stock of the economys liquidity and inflationary conditions and employs the necessary tools to revive it. Monetary policy can be summarized as the central banks actions to influence the availability and cost of money and credit in the economy. The primary objective of these actions is to ensure price stability. The policy directly affects the Banking and Financial System as flow of credit to various activities come from banking system and indirectly affects, trade and industry as the interest rate, credit flow and margin money requirements are dealt with. Agricultural sector is not generally affected as it is always ensured adequate credit through priority sector prescriptions. Monetary policy will seek to answer important questions that impact the well-being of the economy, companies as well as individuals Objectives of the Monetary Policy The monetary police of RBI aim at twin objectives of price stability and growth by ensuring adequate flow of credit to the productive sectors of the economy. While maintaining a judicious balance between price stability and economic growth, the relative emphasis between the two is governed by the prevailing circumstances at a particular time. Apart from these two important goals, there has been a conscious attempt, on the part of RBI in recent years, to maintain orderly conditions in the foreign exchange market and curb destabilizing and self-fulfilling speculative activities. This has assumed strategic importance for the sustainability of the external sector in the face of growing cross border capital flows into the economy. Instruments of Monetary Policy The RBI uses different direct and indirect instruments to control credit. Direct instruments include cash reserve (CRR) and/or statutory liquidity ratios (SLR), directed credit and administered interest rates. Indirect instruments generally operate through repurchase (Repos) and purchase and sale of government securities (open market operations). The reforms in the financial sectors have enabled RBI to expand the array of instruments at its command. While the prime target of monetary policy continues to be banks reserves, the use of the same is sought to be de-emphasized and the liquidity management in the system is being increasingly undertaken through open market operations (OMO), and Repos.

Assistant Professor, Sree Narayana Guru Institute of Science and Technology, Thekkethezham, Mannam (PO), Ernakulam Dist., Kochi 683 520. sreenivas_vasu@myway.com

CRR/SLR: Cash reserve ratio (CRR) determines the level of cash banks need to hold against their net demand and time liabilities. Similarly, statutory liquidity ratio (SLR) requires banks to maintain a part of their liabilities in the form of liquid assets (e.g. government securities). Bank rate: Bank rate is the rate at which RBI lends to the banking entities to meet their liquidity requirements. Interest rates: Credit and interest rate directives take the form of prescribed targets for allocation of credit to preferred sectors or industries and prescription of deposit and lending rates. OMO and LAF: Liquidity management in the system is carried out through open market operations (OMO) in the form of outright purchases or sales of government securities and daily repo and reverse repo operations under Liquidity Adjustment Facility (LAF). Market Stabilization Scheme (MSS): The liquidity impact of large inflows was managed till the year FY04 largely through the day-to-day LAF and OMO. In the process, the stock of government securities available with RBI declined progressively and the burden of sterilization (sucking out excess liquidity) increasingly fell on LAF operations. In order to address these issues, the Reserve Bank in March 2004 signed a memorandum of understanding with the Government of India for issuance of treasury bills and dated government securities under the MSS. The intention of MSS was essentially to ensure liquidity absorption of a more enduring nature by way of sterilization against the day-to-day normal liquidity management operations (Equitymaster News Letter, www.equitymaster.com) Recent measures: With the revival in credit demand and inflation that RBI hiked the CRR to 7%, SLR 25%, Bank Rate 6.0% Reporate 7.75% Reverse Repo Rate 6.00%, PLR 12.75% 13.25% and Deposit Rate 7.50% - 9.60%..(www.rbi.org.in). This is in tune with the central banks reiteration from time to time that it would continue to pursue its objective of economic growth and price stability by controlling inflation. Stock Market Performance and Monetary Policy. It is always evident that the stocks in the stock market perform well based on the performance of those companies. The interest rate and credit flow in to the market determines the performance of Banking and Auto sectors in particular and other sectors in general. Due to recent monetary policy, the interest rates have increased and credit flow from the commercial banks came down. This mostly affected the stock prices of banking and automobile companies. The Banks stock prices declined due to lower lending and higher interest rates. Due to higher interest rates, the sales of automobile companies have declined resulted in declining their share prices. RBIs decision to increase the CRR and Repo rate together to taming inflation, during March 30th to April 7th, BSE and NSE fall 1% and 1.2% respectively. The major losers were Bank and Auto Indices which fell by 2.6% and 5.4% respectively and others also fell slightly.

Table - 1 Stock Market performance during March 30th to April 7th

Index As on March 30 As on April 7 % Change BSE SMLCAP 6,471 6,456 -0.2% BSE PSU 5,922 5,917 -0.1% BSE OIL AND GAS 6,419 6,370 -0.8% BSE MIDCAP 5,384 5,320 -1.2% BSE METAL 8,488 8,624 1.6% BSE IT 4,899 4,822 -1.6% BSE HEALTHCARE 3,649 3,647 -0.1% BSE FMCG 1,739 1,720 -1.1% BSE BANKEX 6,542 6,372 -2.6% BSE AUTO 4,869 4,606 -5.4% Price on Price on % 52-Week March 29 (Rs) April 5 (Rs) Change H/L (Rs) BSE Sensex 12,980 12,856 -1.0% 14,691 / 8,799 S&P CNX NIFTY 3,798 3,752 -1.2% 4,232 / 2,596 Data Source : Equity master News Letter, www.equitymaster.com Indices

The gains during April 20th to April 27th 2007 were resulted from the RBIs decision to leave rates unchanged for the time being and this led investors to buy into banking and other interest rate sensitive sectors. Due to this though the BSE and NSE Index increased marginally, the BSE Bank Index And Auto Index have gained substantially by 2.5% and 2.3% and others have small gains and small losses. Table - 2

Stock Market performance during 20th April to 27th April 2007

Indices As on April 20 As on April 27 % Change BSE BANKEX 6,914 7,087 2.5% BSE AUTO 4,831 4,945 2.3% BSE PSU 6,353 6,420 1.1% BSE MIDCAP 5,699 5,734 0.6% BSE FMCG 1,812 1,821 0.5% BSE OIL AND GAS 7,052 7,078 0.4% BSE METAL 9,702 9,726 0.2% BSE SMLCAP 6,974 6,941 -0.5% BSE IT 5,055 4,954 -2.0% BSE HEALTHCARE 3,793 3,696 -2.6% Indices Price on April 20 (Rs) Price on April 27 (Rs) % CHANGE 52-WEEK H/L (Rs) BSE SENSEX 13,897 13,909 0.1% 14,724 / 8,799 S&P CNX NIFTY 4,084 4,084 0.0% 4,245 / 2,596 Data Source: Equitymaster News Letter, www.equitymaster.com

The RBI has permitted nine banks, including SBI and PNB, to transfer their investments in nonSLR (statutory liquidity ratio) bonds issued by the development finance institution, IFCI, to available-for-sale (AFS) category from held-to-maturity (HTM) by the end of June 2007. This move will entail a hit of around Rs 7 bn on the bottom line, as the banks will now have to provide for depreciation in the value of these bonds. When the IFCI debt restructuring exercise was undertaken in FY03, the central bank had allowed banks to hold non-SLR bonds issued by IFCI in the HTM category to avoid mark-to-market losses. However, in May 2007, the central bank told the banks to transfer their exposure in the non-SLR bonds and debentures to the AFS category. According to RBI guidelines, only SLR bonds can be held in HTM category. The RBI had given the special concession to the banks when the debt of IFCI was restructured and now wants to withdraw it, since time has lapsed and IFCI's repayment capacity has improved (Equitymaster News Letter, www.equitymaster.com). Due to these changes, the banks got freedom to some extent and the BSE BANKEX increased by 5.0% and BSE Auto by 2.8% along with other indices except BSE IT Index. Table - 3

Stock Market performance during 15th June to 22nd June 2007

As on As on % June 15 June 22 Change BSE BANKEX 7,462 7,835 5.0% BSE PSU 6,500 6,720 3.4% BSE MIDCAP 6,181 6,374 3.1% BSE AUTO 4,675 4,805 2.8% BSE METAL 10,496 10,745 2.4% BSE SMLCAP 7,350 7,513 2.2% BSE OIL AND GAS 7,457 7,594 1.8% BSE FMCG 1,789 1,818 1.6% BSE HEALTHCARE 3,795 3,824 0.8% BSE IT 4,996 4,858 -2.8% Indices

Price on Price on % 52-Week June 15 (Rs) June 22 (Rs) Change H/L (Rs) BSE SENSEX 14,163 14,467 2.1% 14,724 / 9,875 S&P CNX NIFTY 4,171 4,252 1.9% 4,363 / 2,878 Indices Data Source: Equitymaster News Letter, www.equitymaster.com

It is always evident that the Stock Market reacts when ever there is change in the RBIs policy. This phenomenon is common as RBI is the apex bank which controls the money in the market. Certain external factors which are out side boarders of the country also influence the performance of Stock Market.

Conclusion
The monetary policy is not the only policy responsible for the Stock Market performance. In addition to that, the environment of increasing capital inflows through the participation of FIIs, cross-border interest rate differentials (eg. Fed rates vis a vis Indian G-Sec rates) and surplus liquidity conditions, exchange rate movement tend to have linkages with interest rate movements in the country. The challenge of the monetary authority (i.e. RBI) is to balance the various choices into a coherent whole and to formulate a policy that can best facilitate the countrys economic objectives as well as stock market performance.

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References:

1. Elasticites relevant to Monetary Policy, P. R. Bramhananda, August 31st 2002. 2. FIIs keeping tabs on the Movers and Shakers, Raghuvir Srinivasan, the Hindu, September 23rd,
3.

4. 5.

2007 Inflation rates as anchor for Monetary Policy, Business Lines Investment World. Monetary Policy with inflation bias?, Business Line, S. Balakrishnan June 11th 2003. Report of the Committee on Liberalisation Foreign Institutional Investment, www.finmin.nic.in

Web Sites:

1. 2. 3. 4.

www.equitymaster.com www.moneycontrol.com www.bse-india.com www.nse-india.com

DECLARATION I, Dr. Kuppachi Sreenivas, here by declare that the article entitled, MONETARY POLICY AND STOCK MARKET PERFORMANCE, is a original work done by me. It is prepared based on the existing situation in stock market and referring some articles and web sites where from the data is collected. Where ever information / data are presented, it was quoted with reference. The article is my original work and it has not been published in any journal earlier and was not presented in any seminar by me or any other person for award of any thing.

Place : N. Paravur Date : 3 9 2007 Dr. K. Sreenivas.