Though the changes in both unemployment and, inflation levels, in themselves may not have been enough to convince the US Fed that it was time to start hiking rates—inflation is still at under 0.5% versus the target of 2%—the role of expectations was probably more important. With seven years of near-zero interest rates and continuing problems in Europe, Japan and China, market participants had started to believe the Fed’s inability to raise rates was a sign that it believed the economy was still fragile—perversely, the fact that the Fed has hiked rates and suggested a trajectory to raise them by 100 bps more over a year underscores confidence in the economy; in any case, the near-zero rates could have accentuated asset bubbles in the economy and also disincentivise savers. Also, as Fed chair Janet Yellen said in her post-policy press conference, since it takes time for monetary policy to have an impact, not starting normalisation of interest rates could have led to a situation where a behind-the-curve Fed would be forced to tighten too suddenly and push the economy into a recession.
There are obvious issues of concern for emerging economies like India since there has been an exodus from all emerging markets over the past few months in preparation for the US beginning to tighten liquidity in order to get rates up. Since March 19, the first day of trading after the Fed removed the word ‘patient’ from its official statement, and markets began to expect a rate hike, India has seen over $2.5 billion flowing out. To put this in perspective, by April 21—when India’s FII inflows peaked—total FII inflows were $8.6 billion; thanks to the huge outflows over the past few months, these are down to $2.7 billion today. If all emerging markets are going to find their funds choked, surely India will be in the same boat, more so since consensus earnings for FY16 have been cut by 20% so far—of course, India’s stable macros make it a better investment within the EME universe.
Given how exports have fallen 18.5% in dollar terms between April and November, India obviously has reason to be cautious—it is true the current account deficit remains under control; it is likely to be around 1% in FY16. But once the economy picks up, this will start deteriorating; there are several structural reasons why India’s exports are likely to remain poor in the short term. The saving grace here, is that despite projections of oil falling to $20, the Fed seems to believe oil will remain at around today’s levels—it talks of the impact of the collapse in energy prices dissipating over time —as a result of which, India’s $65-70 billion of annual remittances, largely from the Gulf, may not get hit too badly. The fact that India’s forex reserves are now up to around 11 months of imports also gives the central bank more room to defend the rupee if need be, and will prevent punters from taking a shot at the rupee as they did some years ago. It also helps that India’s FDI—$16.6 billion during April-September this year—would also be higher than the projected current account deficit, thereby lowering the vulnerability to volatile FII flows.