The US central bank recently raised its benchmark federal funds rate for the first time in more than nine years. The rate had been next to zero since December 2008 and is now increased by a quarter points. This move affects everything from capital flows to stock markets. Experts say that this move is just a beginning of rate hike process. Raising of interest rates means all those who have been using ‘free money’ and those who intended to will have to pay for it. Investors who have used and deployed it in emerging markets have a built-in cost, the hedging cost of currency fluctuation. Rise in interest rates signals that the country’s economy is doing well and investors would rather bet on the US markets than the riskier emerging markets (EMs), since they save on the cost of hedging.
In October 2014, the Fed ended quantitative easing after injecting $3.5 trillion into the American economy. Now, the Fed has raised interest rates just a wee bit, but this has massive implications for the global economy. The cost of capital has gone up after years of free money for banks. This will make credit more expensive for borrowers. This hike will strengthen the dollar vis-s-vis other currencies. This means that money might flee other economies to gush into the American economy because the US will be more of a safe haven as China stumbles, emerging economies wobble, Japan remains paralysed and the eurozone crisis carries on. The strengthening of the dollar will make imports expensive for emerging economies. Volatility will certainly increase in the global economy. Fewer investment dollars will now leave American shores. This might exacerbate the slowdown in emerging economies.
With the exception of 2011, foreign investors have been net buyers of domestic equities in the last five out of six years since 2009. But with this hike, some foreign investors are expected to book profit in their holdings in Indian shares and bonds; they are likely repatriate funds back to the US, where buying high interest rate bearing bonds will become an attractive bet. A dollar outflow and the resultant slide in the rupee’s value could hurt profitability of many companies in India. Companies that borrowed dollars from overseas banks will be the worst hit as repaying loans will become costlier, hurting bottom-lines. India’s retail inflation has crept up to a 14-month high of 5.41% in November driven by costlier food items. While retail inflation measured by the consumer price index (CPI) that captures changes in shop-end prices inched up from 5% in October, wholesale prices also mirrored a similar rising trend. A weaker rupee could fan inflation further. Imported raw material such a copper, aluminum and machinery will turn costly and squeeze profit margins. This may prompt companies to raise prices of consumer goods such as cars and televisions.
However, according to some experts, the impact of a rate hike in the US on India will be limited because of strong fundamentals. As a net commodity exporter with limited dollar debt exposure, healthy foreign exchange reserves and a stable polity, India should suffer at worst a slight drop in the rupee’s dollar value. Even this may be temporary as money flowing out of badly-affected economies may be redirected to India. India is better placed than the rest since its fiscal deficit is shrinking, current account deficit is reasonable at 2%, its dependence on exports is limited and external balances are improving. Also with a small part of India’s sovereign debt being held by foreigners or denominated in foreign currency, chances of rupee emerging a gainer in the near-term are high. Though in the short-term, capital outflows and weakness in stocks and bonds are anticipated, markets should be prepared for volatility, if the Fed makes aggressive moves.