'Interest'ing impact: - Views on News from Equitymaster

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'Interest'ing impact:

Jun 15, 2004

Indian stock markets gained enormously during FY04 with the BSE-Sensex and the NSE-Nifty gaining by 82% and 80% respectively. However, the recent spate of events (domestic and international) that have caused much volatility in equities compelled us to take our audience's view as to what all factors have determined the movement of the Indian markets. As a part of that process, we polled our viewers last week whether they thought that a hike in the US interest rates would affect Indian stock markets. The response
The poll results as shown below indicate that a large number (71%) of voters believe that a northward shift in the Fed rates would actually affect Indian stock markets. Another 27% believed that the change should not affect the Indian markets while the remaining 2% decided to remain on the sidelines. Quoting a former US President, "the majority is most of the times wrong (historically, governments have proved to be an example!!!)", we believe that the majority of the investors have this time got it right.

Our view
A cut in the Fed rates in the past has usually resulted in inflow of capital into the emerging markets, which offer relatively higher rates. This is due to the fact that in one way the cost of capital comes down (in the US) and as a result Foreign Institutional Investors (FIIs) borrow and invest in emerging markets to play over the spread in interest rates. Higher inflow of capital leads to higher investment in the economy resulting in a boost to the economic performance thereby increasing optimism and triggering more capital inflows. Thus, it is cyclical in nature.

The financial system in the emerging markets has usually been known to cater to short term financial requirements in a much more efficient manner as compared to the long-term risk evaluation and as a result, the positive inflows in the short term seems to be taking the economy to a new trajectory. However, once the Fed indicates an upward shift in the rates, inflows could slow down and to an extent taken back into the homeland to be invested in more secure US treasury bonds and bills.

Just to put things in perspective, the capital that was withdrawn from the South East Asian countries after the financial crisis was invested into the Nasdaq, which led to the index peak. At the same time, the current account deficit moved up and as a result the Fed cut rates so as to cut down on the tech boom. India witnessed a tech boom the following year and we all witnessed the high prices of tech stocks at that point in time.

The above chart clearly indicates the impact of reducing interest rates in the US and the succeeding impact of forex inflows in India. To put things in perspective, forex inflows in rupee terms were Rs 48 bn in FY95 when the interest rates were ranging at 6% in the US and currently at 1%, the forex inflows have touched Rs 158 bn.

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