The RBI has raised its repo rate and reverse repo rates by 0.25% to 6.25% and 6% respectively. The repo rate is the rate at which the RBI lends money to banks and the reverse repo rate is the rate at which the RBI accepts deposits from banks.
The monetary policy committee of the RBI voted unanimously for the rate hike. This is the first hike in four years and may mark the beginning of a rate hike cycle. A cycle of rising interest rates tends to hurt most debt investors except those at the very shortest end of the maturity spectrum (those in liquid or low duration funds). This is because bond prices fall when interest rates rise.
However, the central bank also allowed banks to consider another 2% of their government security holdings as high-quality liquid assets for Basel III norms reducing the pressure on them to raise short-term funds. This may blunt the force of the repo rate hike on bank FD rates and lending rates, to some extent.
In another key decision, the central bank raised the upper limit for priority sector housing loans for economically weaker sections. The upper limit has been raised from Rs 28 lakh to Rs 35 lakh in metros (cities with a population above Rs 10 lakh). In smaller towns, the limit has been raised from Rs 20 lakh to Rs 25 lakh. However, the house itself cannot cost more than Rs 45 lakh in metros and Rs 30 lakh in other towns. This is expected to boost loans for housing. In a parallel decision, the Cabinet Committee on Economic Affairs (CCEA) allowed the use of land owned by sick/closing PSUs for building affordable housing.
The RBI’s rate hike is a result of its expectation of higher inflation and growth. It has raised its inflation forecast for the first half of FY 19 to 4.8-4.9% and for the second half of FY 19 to 4.7%. Agricultural inflation has been subdued but core inflation has risen due to the rise in commodity prices such as oil prices. According to provisional CSO figures, economic growth accelerated in the fourth quarter of FY18 to 7.7%, pushing up growth for the whole of FY18 to 6.7%. Manufacturing showed higher capacity utilisation. The growth pickup also weighed on the RBI’s decision makers.
Impact on Investors
Rising interest rates push down bond prices and hence the NAVs of most debt funds. This also hurts balanced fund returns, as we write here. The Government of India 10 year bond yield has risen to 7.97% after hitting a bottom of 6.5% in August 2017. The RBI decision may mark the beginning of more rate hikes, deepening the losses for debt fund investors.
Stock prices and equity funds have so far proved resilient to rising interest rates. In theory, higher rates increase borrowing costs for companies and pull down share prices. However, this seems to have been counteracted by rising economic growth and demand. However, this scenario can change if the pace of rate hikes increases dramatically.
Banks have also raised both their fixed deposit rates and lending rates. This trend is likely to continue. Other alternatives have also emerged with companies issuing NCDs (Non-Corporate Debentures) at higher rates. DHFL recently issued NCDs up to 9.1% and JM Financial Credit Solutions issued NCDs up to 9.75%. However, investors may be able to get yields of this nature, in a more tax efficient and diversified form by investing in fixed maturity plans of mutual funds as we explain here.