Why a US Fed rate hike may have helped India

By: |
September 18, 2015 4:16 PM

A rate hike by US Federal Reserve may just have helped India, one of the reasons why RBI Governor Raghuram Rajan has been in favour of it, albeit in a gradual manner.

US Fed Reserve Janet YellenThe Federal Reserve ended weeks of speculation Thursday by keeping US interest rates at record lows in the face of threats from a weak global economy, persistently low inflation and unstable financial mark.

Given the global turmoil caused by China, including the deflation which will result from the collapse in demand there, it is not surprising the US Federal Reserve decided not to hike rates. Indeed, the IMF and the World Bank have been cautioning the Fed for this very reason, that should rates be hiked and funds start flowing out of emerging markets, countries like Brazil and Turkey will look even more precarious.

Not surprisingly, most Asian markets including India have had a relief rally this morning. The rally, of course, will be a limited one since with 13 of the 17 FOMC members voting in favour of a rate hike this year, chances are it could be as early as next month, or in December. Indeed, Fed chairperson Janet Yellen described the decision as a close call, driven by ‘heightened uncertainties abroad’. But, as she said, ‘the recovery from the Great Recession has advanced sufficiently far and domestic spending has been sufficiently robust that an argument can be made for a rise in interest rates at this time’. Which is why, the Fed’s economic projections have been raised for most important parameters. In the case of GDP, the median projection for 2015 is 2.1% as compared to a 1.9% projection just three months ago – clearly the stupendous 3.7% Q2 growth played a role in this. As a result, the median outlook for unemployment is down to 5% for the year as compared to 5.3% in June. The inflation outlook, though, is decidedly softer at 0.4% as compared to a projected 0.7% in June – that’s the China factor at work. If anything, that could possibly delay the rate hike a bit, perhaps to December.

Paradoxically, a rate hike may just have helped India, one of the reasons why RBI Governor Raghuram Rajan has been in favour of it, albeit in a gradual manner. While the immediate impact of a rate hike would have been a collapse in the Sensex and, with FIIs pulling out, further pressure on the rupee – that, in turn, would put pressure on Indian corporate that have large global debt or with low levels of hedging to their forex exposure. But this may just have spurred the government into taking more reform measures in order to keep FIIs interested in the country – the finance minister, for instance, has just spoken of resolving major pending tax cases in days. While that is looks ambitious, what it could mean is referring the cases to the AP Shah panel in the hope it is able to resolve the disputes – as happened in the case of MAT on FIIs. Similarly, an FII exodus could speed up decisions such as those on hiking gas prices which would stimulate investments in gas exploration or on scrapping the 5/20 rule that would help new aviation firms. Whether or not a fall in the value of the rupee will boost exports is unclear – the slowing of the global exports trade makes this a bit iffy – but it is clear that high FII inflows have made the rupee stronger than it would have been on the basis of relative inflation.

Besides, the longer the Fed keeps rates low – and this applies to both Europe and Japan also – the longer this gives wind to the carry trade which pushes up FII flows into emerging markets, and the higher the chances of bubbles getting created; India’s markets are, in any case, trading at more than their historical averages, and the spate of earnings downgrades is only making this worse. The saving grace, of course, is that with the Fed not hiking rates, Governor Rajan will almost certainly cut rates on September 29 – while that may not stimulate much consumption or investment demand, it will certainly give relief to overstretched corporate.

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