US FED & EMEs: What the US monetary tightening means for India

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New Delhi | Published: June 26, 2018 3:47 AM

An increase in interest rate by Fed and an anticipated increase in policy rates by RBI could mean fewer new jobs in India—a decrease in overall production would result in companies refraining from hiring new workers.

It is hoped that the Fed rate hike will have short-term implications for the Indian market, but corresponding monetary policy tightening by RBI in response to future Fed hikes may not be an ideal step.

After following quantitative easing and zero interest framework since the global financial crisis in 2008 till 2014, the United States Federal Reserve raised its benchmark short-term interest rate for the seventh time, and the second time in 2018, by 25 basis points to a range of 1.75-2%. The US economy has been steady and is growing with well-achieved objectives—the inflation rate of 2.9% in May 2018 was higher than the targeted rate of 2% and the economy had the lowest unemployment rate of 3.8% in the last two decades. The Fed officials aim for two more hikes this year to stabilise the inflation to around the target of 2%, and strengthen job market through wage gains. Although the Fed hike was anticipated and already factored in by most of the emerging market economies, including India, the recent hike in rate and the expected hikes by the end of this year bear important implications for India and emerging market economies in terms of increased liability on dollar-denominated debt, capital flows, exchange rate appreciation and inflation.

In fact, the low rates since 2008 in the US were followed by Japan and countries in Europe, which led investors into emerging market economies, including India, in search of higher returns, albeit at a higher risk. The current hike and further expected hikes by the Fed would be likely followed by other developed countries, as financial markets are well-integrated. For emerging market economies, including India, a rise in the Fed’s interest rate will weaken their currency against the US dollar.

Furthermore, the resulting increase in the US government securities rates will put pressure on these economies’ government bond yields.

In the short-run, equity investment will move out from these emerging market economies and towards the US market because of the hike and the increase in investors’ confidence.

The foreign institutional investor, or FII, inflows to India are mostly driven by interest rate movement along with growth prospects, and with an increase in the interest rate in the US with a stable and safe financial market, investment will flow back to the US, resulting in a slowdown of dollar inflows into the Indian equity market. As the Reserve Bank of India (RBI) data shows, there was a sharp decline in net portfolio investment to India after the last hike in March 2018. In fact, the net portfolio outflow is of $3,133 million versus the net portfolio inflow of $1,159 million between March and April 2018.

The slowdown of short-term capital inflows along with an increase in the current account deficit—increased from 0.6% of GDP in FY2017 to 1.9% in FY2018—would put pressure on the Indian rupee to depreciate. The value of the rupee already has depreciated by around 5% since the last Fed’s hike in March in order to meet the demands of the dollar outflow, and now it is expected to fall further against the dollar. A weaker rupee means a lower rate of return and, therefore, foreign investors would be less willing to invest in the Indian equity market.

A weaker rupee with sticky import baskets means a higher import bill and imported inflation due to exchange rate pass-through. The only silver lining is that a weaker rupee may improve price competitiveness of Indian exports—and the growing US economy, which was the largest importer of Indian goods and services in the past decade and the largest importer in 2015-16 with a share of 15.3%, will see more demand for India’s exports. As India’s trade is mostly carried out in the dollar, either a stronger dollar or a weaker rupee might help reduce India’s trade deficit.

In addition, higher interest rates in the US will lead to a pressure on emerging market economies to increase their interest rates to secure investment inflows. The monetary tightening by hiking the policy interest rate—by a quarter of a percentage to 6.25%—by RBI in the first week of June can be understood as a decision prompted by an anticipated Fed hike as well as achieving a medium-term target for consumer price index (CPI) inflation of 4% within a band of +/-2%. It was the first hike by RBI since 2014. The hike in Indian policy rate would restrict some of the portfolio outflows, thereby reducing the pressure on the rupee to depreciate. While the tightening of the monetary policy (in the form of raised interest rates) by the central bank can reduce inflation in the Indian economy since money will be more expensive to borrow, but, at the same time, the tightening can also result in a slowing of the overall economic activity by hindering investment activity, which has slowed down since 2008 and is still weak.

Further, an increase in the interest rate by the Fed and an anticipated increase in policy rates by RBI could mean fewer new jobs in the Indian market. In other words, a decrease in overall production would result in higher unemployment rates as companies will refrain from hiring new workers, rather they might even reduce the workforce in some cases.

While RBI is factoring in the expected future hikes by the Fed, still the former needs to be pragmatic before further increasing interest rates as it could severely affect the economic engine of the country.

Moreover, RBI is already keeping a close watch on external factors by maintaining the real interest rate differential and is well placed to intervene to keep the exchange rates in check while maintaining its domestic goals of inflation stability. Therefore, it is hoped that the Fed rate hike will have short-term implications for the Indian market; however, corresponding monetary policy tightening by RBI in response to future Fed hikes may not be an ideal situation. Higher interest rate in the US could result in higher domestic inflation in emerging market economies via the depreciation of their domestic currencies and, thereby, likely trade surpluses in their favour. So, US President Donald Trump’s protectionist measures and a trade war are here to stay.


Pravakar Sahoo & Bhavesh Garg: Sahoo is professor and research scholar, Institute of Economic Growth, Delhi; Garg is with the Indian Institute of Technology, Hyderabad

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