How higher US interest rates hurt the Indian economy2 min read . Updated: 12 Nov 2018, 07:10 AM IST
Higher US interest rates has resulted in surging FII outflows from India, pushing up the demand for dollars and rupee losing value against the greenback
The Federal Open Market Committee (FOMC), the monetary policy committee of the US Federal Reserve, in its latest meeting that ended on 8 November, decided to keep interest rates unchanged. The federal funds rate will continue to be in the range of 2-2.25%.
Why are interest rates so low in the US?
In the aftermath of the financial crisis, which started when Lehman Brothers went bust in September 2008, the US Fed launched an easy money policy. This included pushing the federal funds rate towards 0% and printing and pumping money into the financial system to keep overall interest rates low. The idea was that at lower interest rates people would borrow and spend money, businesses would borrow and expand and growth would be back. This happened, but to a limited extent. Since 2015, FOMC has raised interest rates eight times. It is expected to do so three times in 2019.
Why can higher interest rates be a problem?
The easy money policy of the US Fed was followed by other Western central banks as well. This led to big financial institutions borrowing money in the Western markets at low interest rates and investing it in financial markets (both stock and debt markets) all over the world. With interest rates in the US rising, this arbitrage has started to unravel. As interest rates rise, financial investors will withdraw the money they invested in stock and debt markets around the world. This will lead to falling markets and rising interest rates.
What else has changed since the 2008 financial crisis?
The US Federal Reserve printed around $3.5 trillion in the aftermath of the 2008 financial crisis. It has now started to gradually withdraw that money.
How did lower interest rates help India?
With the US Fed raising rates and withdrawing printed money, low rates in the US and the Western world, which led to a flood of money into India, are on their way out. Between 2009-10 and 2017-18, foreign institutional investors (FIIs) invested ₹ 6.62 trillion in buying Indian stocks and ₹ 3.93 trillion in buying Indian debt. This led to the stock market rallying and low interest rates. The stocks that comprise the BSE Sensex had an average price-to-earnings ratio of 23.8 in 2017-2018, the highest since 2000-2001.
How will higher interest rates hurt India?
In 2018-19, FIIs sold stocks worth ₹ 55,935 crore and debt securities worth ₹ 52,823 crore, explaining why the stock market has fallen and interest rates are up. When foreign investors sell they get paid in rupees. They need to convert these rupees into dollars. This pushes up the demand for dollars and the rupee loses value against it. India will continue to face this risk over the next few years.
Vivek Kaul is the author of the Easy Money trilogy.