August8 , 2022

US Fed Rate: How the US Fed rate hike will impact the Indian economy | India Business News

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NEW DELHI: Now that the US Federal Reserve has raised interest rates by 75 basis points for the second straight month, global financial conditions will remain tight in the coming months and may result in flight of capital flows from emerging markets like India. This will keep the rupee volatile in the near term.
A depreciating rupee will put pressure on inflation too due to higher cost of imported goods and services.
Why did the US Fed increase interest rates?
Globally economies are in a recession due to high inflationary pressure. To combat this, the Fed, which is the central bank of the US, is taking aggressive steps such as increase in interest rates (something which was not seen since the 1990s) to reduce the money supply flow in the economy.
“A lower interest rate in the economy allows the public to take more loans (cheaper debt available) to buy new assets and spend more on buying goods and services. Therefore, the overall supply of money in circulation in the economy increases. This results in higher demand than supply.. This demand-supply gap results in an increase in the price of goods and services, which we typically call ‘inflation,” explains Chaitali Dutta, a personal finance expert.
To combat this, the central bank increases the interest rate to reduce the money supply in the economy, which, therefore, results in a reduction in the price of goods and services. This eventually controls the inflation.
When the Fed raises the rate, it increases the cost of credit across the economy. Higher interest rates make loans more expensive for both businesses and consumers, and everyone ends up spending more on interest payments. Businesses therefore may put their capacity expansion plans on the back burner.
How does it impact India?
When the Fed raises its policy rates, the difference between the interest rates of India and and the US narrows. This making emerging countries such as India less attractive for the currency carry trade. And since India is vulnerable to US rates, it could lead to capital flow out of India, depress the Indian rupee further, prolong imported inflation and prompt more domestic rate hikes, said experts.
How the US Fed rate hike will impact capital flows into India and the rupee
The Reserve Bank of India is expected to hike rates by 35-50bps as the central bank will need to ensure that there is an interest rate differential between India and the US to attract dollars at a time when India is expected to witness a record current account deficit.
“For emerging markets like India, the US Fed hike means higher probability of a rate hike in the forthcoming August 5, 2022 MPC announcement. Cost of borrowing will rise and interest rate sensitive stocks may see some margin pressure,” said .Vijay Bhambwani, head of Research Behavioral Technical analysis at Equitymaster.
Depreciation pressures on the rupee, along with other emerging market currencies, is expected to increase with the US Federal Reserve hiking rates.
An interest rate hike in the US increases the relative returns on dollar investments, leading the US currency to strengthen. The dollar index—a measure against a basket of other currencies—has gained almost 17% in the past year. Hence, with the dollar gaining more strength, India is likely to see more foreign investment outlows.
” When the US Fed hikes interest rates, capital flows more towards the US economy and takes risk assets away from emerging economies like India. And this leads to higher cost of capital, and a re-pricing of risk,” said Rishad Manekia, founder of Kairos Capital.
FII outflows along with the intervention by the RBI is causing depletion of forex reserves adding pressure on rupee. Forex reserves fell to a 15-month low in June 2022. In addition, a widening of the trade deficit to all-time high coupled with downside risks to growth will continue to exert downward pressures on rupee. Dun & Bradstreet expects the rupee to be at 79.8 – 80.0 per US$ band during July 2022.
What does the US Fed rate hike mean for RBI’s upcoming policy review?
State Bank of India Group chief economist Soumya Kanti Ghosh expects the RBI to hike interest rates by 35bps, bringing interest rates to where they were before March 27, 2020 when the central bank began its rate-cutting cycle.
“In our view, the MPC is more likely to be guided by the outlook for domestic inflation growth dynamics, than the size of the Fed’s rate hike. If aggressive Fed tightening brings down commodity prices, it may transmit to lowering domestic inflation readings within the MPC’s comfort zone,” said Aditi Nayar, Chief Economist, ICRA.
“A weakening rupee will put pressure on inflation via higher cost of imported goods and services. Given the tight global financial conditions, coupled with elevated inflationary pressures, we expect the RBI to raise repo rate by at least 75 basis points in remainder of this fiscal, with hikes being frontloaded. Further pace of hikes will depend on the inflation trajectory in second half, and how the US Fed calibrates its moves,” said Dipti Deshpande, Principal Economist, CRISIL Research.
Cross border investment flows will also become restrained as global liquidity has tightened
“The RBI will also be under pressure to hike interest rates, adding to the borrowing cost of firms. Banks have already increased their 1-year marginal cost of funds-based lending rates (MCLRs) in the range of 5-50 bps during June 2022. FII outflows will strengthen causing depletion of forex reserves (which is already 15-month low) adding pressure on rupee. The sharp fall and the volatility of rupee will substantially impact the firms engaged in cross border activities,” said Dr. Arun Singh, Global Chief Economist, Dun & Bradstreet.
The depreciation on rupee is adding to the import cost and growth will slow down
Risks also emanate from geopolitical uncertainty around oil and natural gas raising the probability of widening current account deficit beyond the sustainable limit of 3%. Continued rally in input prices, rising borrowing costs, along with volatility in the financial markets, are expected to restrain the pace of economic activity in India during 2nd half of FY23. Therefore, despite remaining resilient till now, the Indian economy faces a sharp slowdown in the 2nd half of FY23. We expect growth to moderate sharply to 7.1% in FY23 from 8.7% in FY222,” said Dr. Arun Singh, Global Chief Economist, Dun & Bradstreet.
In the latest yearly update of the World Economic Outlook, IMF downgraded growth projections for the US, China and India. “Downgrades for China and the United States, as well as for India, are driving the downward revisions to global growth during 2022–23, which reflect the materialization of downside risks highlighted in the April 2022 World Economic Outlook,” it said.
The IMF has knocked off 0.8% off India’s GDP projections for the current year and has projected India’s gross domestic product to expand by 7.4% in 2022-23, compared to 8.2% it had estimated in April. It cited less favourable external conditions and more rapid policy tightening for the downgrade. The external shocks cited include tighter financial conditions amid higher-than-expected global inflation, a worse-than anticipated slowdown in China, and negative spillovers from the war in Ukraine.
But impact on Indian equity markets will be limited
The market was widely expecting the US Fed hike and hence the 75 basis point rate hike was priced in. Point to note: Rising inflation and the rate hikes amid geopolitical concerns have already dented market sentiment across the globe. And in India, BSE Sensex and Nifty50 are already down around 6 per cent each.
“We believe that the Indian markets have already priced in the hike and the impact is going to be minimal. However, the market expects the rates to stabilize around the ~3% levels by the year-end and any negative surprise could be perilous for the global as well as Indian economy,” said arth Nyati, Founder, Tradingo.
US well behind the curve, India is not
“The US and Indian economies are very differently positioned. The Federal Reserve was well behind the curve and is trying to catch up and subdue inflation which threatens to become systemic. In India, the RBI has stayed ahead and as a result, we don’t see policy rates in India increasing as much as in the US. As such, the impact on the Indian equity markets will be limited to the spillover from the US markets with domestic conditions remaining neutral at the moment. The Indian economy is poised for a long period of growth and acting on such transitory impulses may deprive investors of the long term benefits that are expected to accrue,” said Rajiv Shastri, Director and CEO at NJ AMC.
Profitability of corporates will be hit
“With the objective of bringing down CPI inflation to about 2%, the US Federal Reserve has been tightening rates and reducing liquidity. The hike of 75 bps was as per market expectations and hence was greeted by a short covering rally in the US markets. In India, equity markets, which have been gradually seeing lower levels over the last few months, are witnessing a strong pull back rally today. However, the increase in US rates and tightening of global liquidity in form of quantitative tightening will lead to dampening of demand, which should lead to lower growth and profitability for the corporate world. Also, the opportunity cost of deploying money in markets will go up. Slower growth prospects, lower profitability and higher discounting rates generally lead to lower stock markets,” said Sandeep Bagla,CEO, TRUST MF.
Higher rates of interest in the USA will have an impact on the foreign investment in India
” Investment in the US could be more attractive and safer. To ensure that the foreign investment in India continues at a healthy rate, the foreign investment policies in India would have to be broad based and made more lucrative, in terms of ease of compliance and repatriation. The regulatory policies on recovery of dues by the banking and lending institutions may have to be revisited, as there is likely to be an increase in defaults by retail borrowers. The industrial policy also needs to be relooked to offset the increase in costs due to inflation. The Government may have to provide better subsidies and concessions to the Indian Industry to continue the growth projection in domestic manufacturing and service sector,” said Karan Ajitsaria, Partner, DSK Legal.
Debt funds could be hit, positive for dollar based exporting companies
Returns on debt funds could take a hit because if the rupee depreciates, inflation could go up and RBI will increase rates further. Debt funds don’t perform well during an increasing rate scenario. However, a depreciating rupee is good news for all dollar-based exporting companies. Rupee depreciation is good for all US dollar based exporting companies as their income in Rupee terms will increase. The problem will be faced with companies whose end products are based on imports as a stronger dollar will make imports more expensive.
Fiscal tightening at the household level
Since interest rates are rising globally, India too will feel the pinch. “We can expect calibrated policy tightening of our own in August. This will translate to fiscal tightening at the household level. Big ticket spends may need to be put on the back burner. The costs of borrowing have increased. The RBI has proactively hiked lending rates twice since May. More hikes will follow. Home and car loans will become costlier,z’ said Adhil Shetty, CEO, Bankbazaar.com.



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