The See-saw Effect of Interest Rates and Stock Prices

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The See-saw Effect of Interest Rates and Stock Prices


Regardless of the various methods used to measure the movement of share prices, the nature of the stock market is mostly considered unpredictable the world over. The market works under several factors making it highly sensitive towards various influences and economic variables. One important determinant in the movement of stock prices is the bank interest rates. 

The fundamental principle for the relationship between interest rates and stock prices has been noted repeatedly as being negatively correlated.

“Higher interest rates represent low gravitational pull on stock prices.”

This theory is backed up by several reasons. A reasonable hypothesis here is - investors are willing to borrow margin loans (loans against stock certificates as collateral) at lower interest rates. It conversely means charging higher interest rates on margin loans discourages investors, leading to lower demand of loans for investing in stocks. Also any investor before making a decision will first compare the risks and returns. Basically, interest rates on deposits are termed as risk-free returns. If the interest rates on deposits are increased, the risk-averse investors are likely to be attracted towards safer investment in fixed deposits and government bonds making the stock less lucrative for investment. 

“Increase in deposit interest rates will exert a downward pressure on the capital flow in the stock market,” says Priya Raj Regmi, chairman of Stock Brokers Associations of Nepal (SBAN). “Interest rates on loans will automatically increase if interest rates on deposits are hiked,” he says. “It negatively impacts the stock market because activities such as margin lending and borrowing money to invest in stocks will decline,” he adds. 

Normally, a negative correlation between these two determinants has always been the case. However, future probabilities should not be completely neglected. One scenario where banks make good returns with a higher interest rate is when the economy is doing well. In such a situation, if banks increase their interest rates on loans, businesses will be willing to borrow money because the economic opportunities will be too good to miss. 

 “Globally, it has been seen that if investors only follow the trends on fluctuations of interest rates even without engaging in many mathematical and technical analyses, their chances of becoming successful in stock trading will be close to 70 percent,” opines Ambika Prasad Paudel, Chairman of Nepal Investors Forum. According to him, the other 30 percent depends on how the market reacts on account of the different macro-economic variables. 

The last two years haven’t been pleasant for Nepali stock investors. The severe shortage of lendable funds in the country’s banking sector in 2016 and 2017 had a dreadful impact on stock investments. This problem further escalated with the excessive supply of shares issued by BFIs in the form of right shares.

Several factors played a role in the shortage of investible money in the banking sector. Basically, the main pressure for banks came in the form of the paid-up capital increment announced by the central bank in 2015. After the end of the unofficial economic embargo imposed by India, BFIs started to lend money aggressively and engaged in a right share issuance spree in a bid to meet the new paid-up capital requirements set by the central bank- eventually leading to the shortage of investment-grade liquidity in the banking sector. 

Here, bank interest rates acted out as one of the factors contributing to the rout in the stock market. When the wave of panic started among BFIs when they realised they were running out of investible cash, banks started raising interest rates on deposits in a competitive manner so as to attract depositors. Alongside the hike in deposit interest rates, lending rates were also increased simultaneously. This created a situation of sell orders at brokerage firms as stock investors hustled to minimise losses and deposit their money in fixed deposit accounts. 

The interest rates on both lending and deposits became so volatile that bankers themselves had to intervene in order to bring stability to the financial market. On June 21, 2018, the executive committee of the Nepal Bankers’ Association (NBA) reached an agreement to cap the interest rate at 11 percent for individual depositors and 10.5 percent for institutional depositors. Similarly, NBA had also set the interest rate on savings deposits at a maximum of seven percent. 

The situation began to stabilise after the money in the financial system began rising gradually with the approaching fiscal year end. It was largely due to the rapid capital expenditure of the government towards the end of the fiscal year which has become a ritual in Nepal. The Monetary Policy for FY2075/76 unveiled by NRB Governor Dr Chiranjibi Nepal on July 12 offered further breathing space for Nepali stock investors. The central bank in the new monetary policy took some steps to address the shortage of investible funds in the banking sector and stabilise bank interest rates. The reduction of both Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) by a maximum of 200 basis points in the new monetary policy is expected to increase the lending capacity of banks by around Rs 50 billion. According to the current values of deposit expansion multiplier and money multiplier, the additional money released from the central bank's coffers to the banking system would enable the banks and financial institutions to create a fresh credit of around Rs 200 billion. 

With the rising liquidity level in the country’s banking system, bank interest rates are likely to be stable in the long term. Also, the target given by the new monetary policy to commercial banks to bring down the spread rate, the difference between deposit and lending rates, at a maximum of 4.5 percent by the next fiscal year can be another important step in terms of ensuring interest rate stability. The central bank has, however, decreased the margin lending limit of a bank from 40 percent to 25 percent of the core capital. This restrict the capital market growth. Nevertheless, the provision is claimed to be aimed at creating interest rate stability.

Visualising all the past scenarios and data, it can be seen that an inverse relationship of interest rates and stock price movements exists in the capital market of Nepal. But no matter what the principles or the facts suggest, the stock market is always functioning in the interests of investors. The difference is in how they react to changing market conditions which creates volatility in the index. Investors who follow the ongoing trend in the market and act accordingly will always find a way out to keep themselves safe from the difficult situations.

The author is a BBA fifth semester student at Kathmandu College of Management.​

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