Changes in US won’t trump India

Last month, the Fed announced a rate hike by 25 basis points to between 0.5 per cent and 0.75 per cent. This is the second hike in the last decade, and the first since December 2015. Fed Chair Yellen has called it a “modest adjustment” in the context of a strengthening US economy.

The hike can also be seen as a measure to counter the increase in inflationary expectation after Donald Trump’s presidential win. Trump’s keen focus on reducing tax for corporates and individuals, while maximising government spending, especially in the defence and infrastructure sectors, accounts for this. There is always a lag in a monetary policy’s effectiveness, and therefore, the Fed’s hike will help keep future inflation in check.

Reasons

The reasons for the Fed’s rate hike are quite clear — the revival of the US economy and recent economic indicators may have motivated the move. The US economy was booming in the build-up to the financial crisis in 2008. After the crisis unfolded, the US economy was hit by a recession and activity slowed down. There was a dip in the Index of Industrial Production (IIP) from 105 in2007 to 89.6 in 2009 during the crisis period. However, the economy recovered from this setback and has lately been showing an upward trend where manufacturing growth is marginally outpacing total IIP growth. In fact, manufacturing growth and IIP have almost reached pre-crisis levels.

Similarly, the NASDAQ index has registered growth beyond its pre-crisis numbers. The NASDAQ index was 1483.39 in 2008-Q4, which increased to 5309.89 in 2016-Q3. Since the last Fed hike in December 2015, the NASDAQ index has increased by more than 800 points, showing strong stock market growth of around 17 per cent. The unemployment rate reached 4.6 per cent in November 2016, which is the lowest in the last nine years. Earlier, during the crisis period in October 2009, the unemployment rate spiked to 10 per cent. All these favourable economic outcomes led to the Fed’s rate hike.

It can also be argued that the current hike may backfire given that Trump has plans for huge fiscal stimulus in the future. The US is a consumer-driven economy and runs huge current account deficits, and therefore, massive fiscal spending will result in a significant increase in its imports, unless trade protectionist measures are enforced, thereby weakening the dollar and ultimately feeding into inflation. This would partially or completely offset the gains from the increase in rate.

For emerging market economies (EMEs) including India, an increase in the Fed interest rate will weaken their currency against the dollar. Furthermore, the rise in US government securities rates will put pressure on these economies’ government bond yields. In the short-run, equity investment will move out from these EMEs and towards the US market because of the hike and the increase in investor confidence. Following the hike announcement, the yields on 10-year government bonds in major EMEs like China, India, Brazil, Mexico and South Africa have increased marginally. Similarly, the dollar strengthened by a small amount against these EMEs’ currencies.

The Fed’s announcement could negatively impact EMEs’ currencies and the Indian rupee. Portfolio equities have already pulled out of Indian markets since the demonetisation drive, and the Fed rate hike would further aggravate this situation. We might see short-term volatility in equities and the exchange rate market. Since the demonetisation drive, FIIs have been selling their holdings, and the Fed’s rate hike could induce investors to park their funds in US markets as they widen their demand for international capital flows.

Volatility

Earlier, net sales of FIIs increased from Rs 57.7 billion in October to Rs 113.25 billion in December, mainly due to demonetisation, and this has put pressure on the RBI to maintain the exchange rate and reduce volatility in flows.

Due to the hike, the rupee is expected to fall against the dollar in the near future. A weaker rupee means that foreign investors would be less willing to invest in Indian markets. In addition, the recent agreement between OPEC and non-OPEC members to cut oil production could also result in an increase in oil prices. This will increase imports as the demand for oil imports is inelastic in nature, and this increase in prices might feed into inflation in the domestic sector.

Economy

On the other front, the weakening of the rupee, and at the same time, the strengthening of the US economy may boost India’s exports. The US has been the largest importer of Indian goods and services in the past decade. According to the RBI, the US was the largest importer of Indian goods in 2015-16 with share of 15.4 per cent. A weaker rupee will improve India’s export competitiveness, and a growing US economy will increase the demand for India’s exports. However, this gain in competitiveness may be offset by the slowing of economic activity in the domestic sector due to demonetisation and the general slowing of exports in the last two years.

To counter the depreciation in the rupee, the RBI has intervened in the past one month. Although foreign exchange reserves have declined by more than $7 billion from $367.04 billion to $359.67 billion in the last six weeks since November 11, India’s international reserve position has been sufficiently good to absorb this external shock.

The RBI is already keeping a close watch on external factors by maintaining the interest rate and intervening to keep exchange rates in check. While the Fed rate hike has short-term implications for Indian markets, the impact will be lesser in India, as the country still holds an attractive position because of its strong fundamentals.

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