The Reserve Bank of India (RBI) governor, Urjit Patel, recently wrote an article in the Financial Times, urging the US Federal Reserve to slow down its monetary policy tightening to avoid extreme volatility in emerging markets. It is interesting how central banks of major economies (especially the US) have to not just look into domestic factors for monetary policy decisions, but also be conscious of the impact of their decisions on other economies. Defending the rate hikes, the US Federal Reserve chairman recently commented that the role of US monetary policy on foreign domestic conditions was “often exaggerated".

In 2013, in what is now termed as taper tantrum, we saw how severely the global market sentiments were impacted just by an indication of reduction in quantitative easing being done by the US Fed. Cut to 2018. The US has already hiked policy interest rate seven times in the last two and half years and indicated two more rate hikes in 2018. Even with the global growth on a much better footing in 2018 than 2013, the recent rate hikes by the Fed has sent nervous ripples down the financial markets.

The recent US Fed fund rate hikes have been accompanied by increased issuance of US treasury bonds to fund the widening budget deficit. This has resulted in US dollar tightening in the market and increased outflows of US dollar from the emerging economies. According to the Institute of International Finance, foreign investors pulled out $12.3 billion from emerging markets in May, the largest monthly outflow in the last 18 months. There has been a sharp weakening of emerging market currencies with the Argentine peso and Turkish lira weakening by 43% and 16%, respectively, since April. Both these economies have a current account deficit (CAD) higher than 5% of gross domestic product (GDP). There is a concern that a sharp strengthening of dollar and outflows from emerging economies could hit hard countries that have a high CAD.

What does an increasing US Fed rate and strengthening dollar mean for the Indian economy? Indian currency has weakened by more than 5% since the beginning of the fiscal year. While the depreciation of Indian currency is lower than the Argentine peso and Turkish lira, it is higher than many other Asian currencies. There have been sharp foreign institutional investment (FII) outflows of $9 billion from India’s stock and debt markets in the fiscal year so far. This is happening at a time when India’s CAD has jumped up to around 2% of GDP compared to 0.4% of GDP a year ago. Foreign direct investment (FDI) inflows growth has also slowed. As the CAD widens further and FII inflows dwindle, India’s balance of payments (BoP) could slip to deficit. With high forex reserves of more than $400 billion, a deficit BoP situation should not be a big cause of concern. Gradual weakening of the rupee will in fact support India’s exports, which have been performing poorly even with global trade improving. On real effective exchange rate (REER) basis, the Indian rupee appears to be still marginally overvalued, going by the average value of this measure for the last five years. Hence some weakening of rupee would help India’s export gain competitiveness. The concern is mainly on any sharp weakening of the rupee, which catches unhedged corporates unaware.

To prevent the rupee from weakening sharply, the RBI has been selling dollars in the forex market, resulting in forex reserves falling by $17 billion in the fiscal year so far. As the RBI sells dollars, it results in rupee liquidity getting sucked out of the system. The RBI has been intervening in the forex market partially through forward contracts and buying government securities through open market operations to inject liquidity in the system. With lower forex inflows, liquidity in the system could move towards deficit scenario, which will put upward pressure on interest rates. Factoring in the external environment, India hiked its policy interest rate recently and may hike it more. For the Indian economy as a whole, a marginal increase in interest rate is unlikely to topple the growth trajectory.

The Fed has learned its lesson from the taper tantrum and has been cautious with hiking interest rates. The higher interest rates decision of the Fed is based on domestic macro scenario of improving growth, rising inflation and supported by improving global growth outlook. Indian macro fundamentals are also much better compared to 2013. India’s GDP growth is projected above 7%, inflation is currently in the 4-5% range as against the 10% level in 2013. Also, the twin-deficit problem is relatively milder now (CAD around 2% and Centre plus state fiscal deficit around 6%) compared to 2013 (CAD at a high of 4-5% and combined fiscal deficit at 6.7%).

Investor sentiments are reflecting better macro fundamentals for the Indian economy. While the MSCI emerging market stock index has fallen by 9% in the last three months, the Indian stock market (Sensex), supported by domestic investors, has risen by 6% in the same period. Having said that, we must note that overall global sentiments are currently edgy because of looming risks like high crude oil prices, trade war and European Union’s political concerns. Risky assets like stock markets are globally overvalued. Hence there are chances that the global risk-off sentiments get triggered by any risk event and are aggravated by the tightening dollar liquidity. Any extreme risk-off sentiments will defy all fundamentals and logic and in such a scenario, Indian markets and the economy cannot remain unscathed.

Rajani Sinha is a corporate economist based in Mumbai.

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