How the Federal Reserve Interest Rate affects India

In the previous article, we explained why the entire world was fixated on the Federal Reserve Meeting on 16th and 17th September, and their decision on interest rates. Today, we explore the impact of Interest Rates on India.

To recap:

  1. The Federal Reserve fixes the interest rates that end up affect the amount of liquidity in the U.S Domestic economy.
  2. The sheer size of the U.S economy means that this has a significant impact on global liquidity. Emerging economies, in particular find access to capital much easier.
  3. However, too much liquidity often leads to bubbles and inflation

How has a hike in interest rates affected India in the past?

2006 ended a 2 year period interest rates were raised 17 times — from 1 percent in June 2004 to 5.25 percent in June 2006.

Federal Rate Chart

If you remember, this was a time of high growth in the Indian economy. The US rate hike triggered a sudden outflow from the debt market, including Government Bonds, with Foreign Institutional Investors (FIIs) reducing their exposure from $1.77 billion in December 2004 to $550 million by June 2006.

On the other hand, Indian equities actually grew strongly — from Indian $30.6 billion in May 2004 to $165 billion by 2006.

However, that was a very different time economically. Asset classes were doing well and there were fewer global macro-economic uncertainties.

How a rate hike will hurt India

Despite the difference in the situation, the real concern remains on the debt market. A rate hike, particularly amidst the uncertainty, would most likely lead to a sudden outflow, leading to a downward pressure on the Indian Rupee. Given the way markets react, a free fall isn’t impossible, although the RBI is likely to intervene in such a scenario. A fall in the value of the Rupee would offset the benefits of the fall in commodity prices, particularly oil.

It also isn’t immediately clear if this fall would help exports because other emerging market currencies would also fall. Weak global growth would also be an impediment.

Finally, it would reduce profit margins as access to capital reduces, and to importers and companies who have unhedged exposure.

How it would help India

India’s equity markets, before the recent fall precipitated by the China meltdown, were trading above historical averages, especially on the back of disappointing earning results. FII inflows have also made the rupee stronger than it perhaps should be, and thus this might lead to a correction in the market, and prevent the formation of a bubble.

It could also spur the government to speed up reforms and decision making. Arjun Jaitley has already promised greater urgency in tax reforms.

Many believe that after the initial days of volatility, India would re-emerge as a preferred investment destination, especially as earnings are expected to improve and other emerging markets continue to face challenges. FII’s would return, but this time because of fundamentals.

Finally, a rate-hike might be good for the global economy, as it sends strong signals that the U.S economy is now back on track. With China slumping, that would do much to lift sentiment.

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