What's in a Fed rate hike? - Views on News from Equitymaster

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What's in a Fed rate hike?

Jun 29, 2000

It seems odd, but it is nevertheless true. Domestic momentum investors have been keenly watching developments in the US, where the Federal Reserve has decided late last night to leave interest rates unchanged. Talk about globalization and how the world is becoming a smaller place. Just a year back US rate hikes did not bother us much. Today, they have put the entire market on ransom. Is there any justification in this?

A country's links with the outside world are reflected by its Balance of Payments (BoP), which comprises the current account (this is where the trade of goods and services is recorded), capital account (comprising among others FDI, FII money and NRI deposits), errors and omissions (not of much significance) and of course the foreign exchange reserves.

Now, how does a rate hike in the US affect India? Let's take the current account first. A rate hike would mean a stronger US currency, which would benefit not only Indian merchandise exports, but also software exports. However, our imports would become costlier (marginal impact on inflation because our import bill as a percent to total GDP is still very small). One can hazard a guess that a declining Rupee would benefit India as in the medium to long term the rate of growth of software exports will far exceed the growth in imports.

The key concerns pertain to the capital account items. Higher rates in the US mean a higher opportunity cost of capital (alternatively they imply higher returns in US$ denominated paper). This could lead to an outflow of FII money and NRI deposits from India (the decline in value of the domestic currency could also contribute to this). Higher rates could also adversely affect US bourses, which in turn could trigger redemption pressures on funds. The other fallout of a higher rate in the US would be a rise in cost of foreign capital for Indian companies. This would affect investment activity in domestic markets.

A rate hike in the US will affect India. Infact going forward, as India becomes more integrated with the world, the effects of interest rate hikes and cuts would be even greater. However, the outcome need not necessarily be negative. As in the present case, it could be a mixed outcome in the medium term. In the short term, a rate hike would adversely affect the economy, as the outflow of funds would be immediate, whereas the anticipated rise in exports would take time to materialize.

The Fed's decision to leave rates unchanged will probably be welcomed by domestic markets. This will largely be due to the anticipation that foreign investors, who have been net sellers in June, will return to the bourses. But one should be cautious, as the reasons for FIIs having been sellers are not clear. Who knows but maybe the reasons are more domestic (Indian) than international!

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