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Posted by: Deepa Vasudevan and Uma Shashikant on Wed, Dec 21st, 2016

Should India Worry about the US rate hike?

Last week the US Federal Reserve increased the target Fed Funds rate by 25 basis points. Backed by data suggesting a strong recovery in employment and growth, the Fed projected three rate hikes of 25 bps each in 2017, and raised its median longer term interest rate projection to 3%. This marks a clear shift away from the massive monetary easing of the post-2008 years; and neatly balances the fiscal loosening that is expected when President Trump takes over in 2017. The rate tightening was widely expected; in fact markets had started pricing in a hike soon after Trump’s election, on the assumption that his campaign promises of tax cuts and infrastructure spending would quickly reflate growth and inflation.

 

There are two reasons for India to be concerned about rising interest rates in the US, and both reasons are connected with its external vulnerability. First, the rate cycle in India appears to be moving in the opposite direction as the US. The yield gap between the 10 year US treasury and the 10-year Govt of India g-sec has narrowed from 5.7% (Jan-Sept 2016) to 3.8% (Dec 1 to Dec 18). Given a rupee-dollar premium of about 4%, a hedged foreign investor will earn zero dollar returns at current spreads. If the RBI cuts rates in 2017, the gap could narrow even more, eliminating any yield advantage of Indian bonds. This has serious implications for foreign portfolio inflows: it must be remembered that the easy inflows of the past couple of years came largely in search of yield. FPI inflows have already started reversing: SEBI data shows that nearly $10 billion of capital left the country between October and December 2016. So far FDI inflows seem to be steady, but they may also be adversely impacted by the growth disruption triggered by demonetisation. India needs foreign capital to finance its current account deficit; and declining or uncertain capital inflows pose a significant risk to its balance of payments.

 

Second, the dollar has strengthened rapidly in the build up the Fed rate hike. The rupee was quoting at 66.5 to a dollar at the beginning of 2016, and it is now rapidly approaching levels of 68 or below. Unfortunately, oil prices have also begun to increase in response to an OPEC agreement on production cuts. A weakening rupee and rising crude is a terrible combination for a net oil importer like India; together, they can set off a vicious cycle of worsening trade deficits, capital outflows and exchange rate depreciation.

 

Yet India is in a far better position than it was in 2013, when a similar set of circumstances triggered off the rupee crisis. As the table below shows, the current account deficit is more manageable, consumer inflation is low, oil price remains within tolerance limits, and forex reserves exceed $360 billion. It is one of the fastest growing economies in the world, notwithstanding the predicted negative impact of demonetisation.

 

Comparing External Indicators: 2013 and 2016

Economic Indicator

2012-13

2016

CAD as % of GDP

4.7

0.6

Price of Indian Basket of Crude ($/bbl)

108.0

44.7 (Apr-Nov 2016)

Consumer Price Inflation

10.2%

5.0%  (Apr-Dec 2016)

GDP growth

5.6%

7.3% (Q2 2016-17)

FDI inflows ($, RBI data)

19.8 billion

20.6 billion (Apr-Sep 2016)

FPI inflows ($, RBI data)

26.8 billion

9.7 billion (Apr-Sep 2016)

Forex Reserves ($)

292.6 billion

362.9 billion (Dec 9, 2016)

Source: RBI, CSO

 

Our economic stability does not take away the fact that the near term outlook faces several stress points. A stronger dollar will inflate the oil import bill, but since crude oil and dollar have historically always moved in opposite directions, it is also possible that a rising dollar will cap the increase in crude prices. Revenues of IT companies could be impacted by the tighter visa quotas and trade protectionism advocated by the new US Government; but they will benefit from a weaker dollar.  Dollar borrowing rates are set to go up; the 3-month US Dollar Libor- a key international short term rate to which many corporate loans are pegged- approached a high of 1% for the first time after the 2008/09 financial crisis. As a result Indian companies will find it harder to borrow overseas at cheap rates; and those with dollar liabilities will have to pay more to repay their obligations. Exports should benefit from a weaker rupee, but the growth in merchandise exports is not likely to improve unless global trade picks up.  On the domestic front, demonetization has probably set growth back by two to three quarters, especially through stalled consumption growth. This means that demand growth will depend largely on government spending, which itself is constrained by fiscal targets and tax collections.  With so many uncertainties, financial markets will be volatile and highly sensitive to any negative news. The US may have put itself on the path to normalcy, but for India, uncertainty will be the new normal for some time. 

Pankaj Mishra on Thu, Dec 22nd, 2016 12:55:44 pm

Thank you so much. It is very usefull article.

Shashidhar S on Wed, Dec 21st, 2016 5:44:01 pm

What I understand from the above is both equity & debt markets are uncertain at least for short-term and baised towards negative zone as dollar is getting strong. Further, what is your view on the most expected rate cuts going forward

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