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Cash Reserve Ratio is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes.

These reserves are designed to satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a bank vault (vault cash), or with a central bank.

The reserve ratio is sometimes used as a tool in monetary policy, influencing the country’s economy, borrowing, and interest rates. Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves; they prefer to use open market operations to implement their monetary policy. The People’s Bank of China does use changes in reserve requirements as an inflation-fighting tool, and raised the reserve requirement nine times in 2007. As of 2006 the required reserve ratio in the United States was 10% on transaction deposits (component of money supply “M1″), and zero on time deposits and all other deposits. An institution that holds reserves in excess of the required amount is said to hold excess reserves.

Cash reserve Ratio (CRR) in India is the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method (increase of CRR rate), to drain out the excessive money from the banks.

From a stock market perspective

Rising interest rates have several implications including – * Results in slow down in the overall growth in the economy; this effectively means that adverse impact of demand for goods and services, and investment activity. Apart from the fact that overall growth is impacted, companies take a hit on account of higher interest costs that they have to bear on their outstanding loans (to the extent their cost of funds is not locked in)  since some investors tend to leverage and invest in the stock markets, higher interest rates increase expectation of returns from the stock markets; this has the impact of lowering current stock prices  an overall decline in stock prices has a cascading effect as leveraged positions are unwound (on account of meeting margin requirements), leading to still lower stock prices

So, from a short term perspective, higher interest rates should adversely impact stock market sentiment. From a long term perspective however our expectations of returns from the stock markets remains unchanged. As mentioned earlier, RBI’s move to tame inflation over the long term augurs well for long term economic growth (there is more predictability and therefore risk premiums are lower). This will ultimately benefit well-managed companies.

So what should you do now?

It’s difficult to say how the stock markets will react; or for that matter to what extent the markets will react. In the last few trading sessions, there has already been a correction of about 4 per centSE Sensex. Any irrational fall in stock prices, in our view, should be seen as an opportunity to add to your exposure, in installments, to equities/equity funds, your planned asset allocation permitting. Your Personalfn consultant will be able to guide you in this regard.

It is impossible to predict near term movement in stock prices. And therefore any investment you consider should be made keeping in mind that in the near term you could be sitting on losses on fresh investments. From a 5 year perspective however we are reasonably confident that a well managed equity fund can deliver returns in the range of 12-15 per cent per year. This is not to say that you will make this return every year. There will be years in which you may lose money, and others where you may make far more than what we have projected. Over the 5 year tenure, on a point to point basis, you will average a return of 12-15 per cent per annum, which in our view is a realistic estimate.

From a debt market perspective

If you are contemplating on investing monies in the debt market, you will benefit from higher interest rates on offer. However, existing investors in debt oriented funds may take a one time hit; but at the same time, since overall interest rates are higher, from here on, such funds will yield higher returns.

So what should you do now?

Although the interest rates have risen quite a bit, it may still not be the best time to lock in all your money in long term debt instruments (interest rates may still rise). Go in for short term Fixed Maturity Plans, which yield attractive post tax returns (you could get an annualised return of about 8 per cent on a post tax basis for a three month deposit). If you can take some risk, go in for well managed Monthly Income Plans (MIPs) that are offered by mutual funds. Go in for the low risk option (equity less than 20 per cent of assets) with a quarterly dividend option. With higher interest rates and possibly lower stock prices, MIPs could yield an attractive post tax return.

From the perspective of a borrower

As a prospective borrower, you are the worst hit. The cost of money i.e. interest rates will rise post the CRR hike. You will probably need to settle in for a lower loan amount given the EMI. If you are an existing borrower, as long as the rate of interest on your loan is fixed, you are immune to any rise in interest rates. However, if you have a floating rate loan, then expect either the tenure of the loan or the EMI to jump soon.