How interest rate hikes by US Fed can affect India

The US Federal Reserve held interest rates steady last week and is on track to raise rates in June, as it has expressed confidence that a recent rise in inflation to close in on its target would be sustained. In March, the Fed raised benchmark interest rates to between 1.50% and 1.75%. It currently forecasts another two increases this year, although many policymakers see three possible rate hikes.

What will the rate hikes mean for emerging markets?

The hikes could reduce risk appetite and raise turbulence, especially in emerging markets with relatively weak economic parameters, corporate fundamentals and political scenarios. Still, if the hikes are measured and in line with consensus, markets will not suffer much damage. If the US economy strengthens at a faster pace and rate hikes are more than expected, that could disrupt emerging markets.

What will be the impact on Indian equities?

There may be some knee-jerk reaction and caution in India. What would be more important is the general election in 2019: if there is a possibility of no clear majority at the centre, foreign investors may prefer to wait for clarity. This, coupled with rate hike pressures, may influence the decision of foreign investors.

What about bonds?

The hikes will lead to a rise in yields on US treasuries and a stronger dollar. The rise in yields narrows the rate differential between the US and India, making Indian bonds less attractive for foreign portfolio investors. Currently, the differential on a 10-year sovereign paper is around 467 basis points. This will reduce if foreign portfolio investors (FPIs) hedge their investments.

How will the rupee react?

A rate hike in the US will lead to a stronger dollar and a weaker rupee, which will lower investment returns for foreign investors and prompt them to sell. Barring long-term FPIs, other foreign investors prefer short-term trade without hedging. A volatile currency may force them to hedge, lowering their returns. Firms that have borrowed heavily in dollars in the overseas market may see higher cost on borrowings.

Will it affect monetary policy in India?

India has an independent monetary policy committee tasked with maintaining retail inflation in a certain band. Currency depreciation resulting from a US rate hike can lead to higher imported inflation. A monetary action in the US impacts global financial and liquidity conditions. These, in turn, determine foreign flows into emerging markets such as India. Hence, a Fed rate hike is an important variable for monetary policy decision in India. However, India can afford to wait and watch for three reasons. First, it does not have a fixed exchange rate, forcing it to copy US action. Secondly, the US is in a policy normalization phase, not monetary tightening. Third, India has built adequate foreign exchange reserves to take care of sudden FPI outflows.

Reuters contributed to this story.