How Interest Rates Affect Equity Markets?

Interest rates are set by central banks all over the world. In India, Reserve Bank of India sets the repo rate. This is the rate at which RBI lends to commercial banks. This becomes the benchmark rate. Commercial banks decide borrowing rates for businesses and people like us based on this benchmark rate. On 29 January 2013, RBI will conduct its quarterly review of monetary policy. According to a survey of 10 economists polled by The Economic Times, a business daily, it is expected that RBI would cut repo rates by 0.25 per cent to 7.75 per cent.

Equity markets would watch out for steps taken by the Reserve Bank of India. Here are pointers that highlight the relationship between interest rates and equity markets:

• High interest rates hurt company profits: In the first half of the financial year 2012-13, companies across sectors paid 3.7% of their sales as interest, according to RBI's monthly bulletin for January 2013. This was just 1.6% four years ago. This ate into company profits. The net profit as a percentage of sales for companies stood at 6.4% in the first half of 2012-13 against 9.2% four years ago

• Small companies hit most: The RBI study of small, medium and large listed companies suggests that small and medium sized companies are hit hardest due to high interest rates. Banks make small companies pay higher interest rate than large companies. The interest paid as a percentage of sales was 9.2% for small companies, 5.8% for medium companies and 3.3% for large companies. RBI defines small companies as those with sales of less than Rs 100 crore. Medium sized companies have sales between Rs 100 crore to Rs 1,000 crore. Large sized companies are those with sales of over Rs 1,000 crore.

• High interest rates reduce domestic participation in stock markets: Investors tend to keep their money in fixed deposits or fixed return assets when interest rates are high. Indian investors pulled out money from equity markets in 2012. For January 2013, mutual funds were net sellers to the tune of Rs 2,770 crore, according to Securities and Exchange Board of India. This means investors in India do not feel the need to take any risk and bet on equity markets. In contrast, low interest rates in US and others markets drove foreign institutional investors to risky assets in emerging markets. In January 2013 so far, FIIs have injected $ 3bn in Indian equity markets.

• High interest rates slow growth: Future growth of companies and expansion is also affected due to persistent high interest rates. Companies struggle to repay existing loans and put on hold expansion plans. This results in fewer jobs than before. Companies also cut spending and consume less. This reduces the demand for goods and services and slows economic growth.

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