Conundrum of interest rate hike in the US

Much in line with the thinking of global financial markets, the interest rates in US have been raised by 25 basis points (0.25 per cent) by Federal Reserve, its central bank. The immediate global market impact has been calm with US $ gaining nominal strength. In fact, many of the markets have gained because preparations to withstand the volatility were larger than it needed.

It only affirms the advantage of market preparedness. The impact of the tectonic shift in the monetary policy stance and interest rate regime in US from ‘easy money’ to ‘dear money’ has been calmed due to reassurance by the US Central Bank about its gradualist approach. Renowned economists and policy makers world over have been fearing wider impact of such policy measures on the other interdependent economies that seek larger overseas investments.

It is indeed a matter of great curiosity for common observer to understand the dynamics of evolving global financial system in the new dispensation. While in India, the economy is passing through a softer interest rate regime with inflation ruling within the expected range of below 6 per cent to be maintained in January 2016 and to eventually reach 5 per cent by March 2017.

GDP is expected to reach 7.4 per cent during the current fiscal. Thus, the recent cuts in interest rates and banks partially passing on the reduced lending rates on to borrowers can step up the revival of the economy. But the current big US move may have its impact on the Indian economy too.

The shift in US policy

RBI has been assuring that Indian financial system can seamlessly manage the transition, keeping volatility at bay. But in integrated financial markets, the developments in a large economy like the US can impact the domestic economy. But RBI has been consistently proactive in preparing the ground well to withstand volatility.

After gradually phasing out in 2013 the policy of ‘Quantitative Easing (QE)’ a process of bond buying and releasing cash into the financial system, the next logical policy move was to harden interest rates. The easy money policy has been pursued to help resuscitate the US economy from the impact of global financial crisis.

As a result, the unemployment rate in the US has drifted to 4.6 per cent from 10 per cent prevailing four years ago and the US economy is now well-poised to post a GDP growth rate of three per cent in 2015. As a result of relative stability in the economic growth, the US intends to phase out all measures of easy money to gradually restore normalcy.

With the news of rate hike by the US Federal Reserve in the pipeline for quite some time, the global financial markets, more importantly, emerging markets having been bracing up to absorb the impact. Many central banks across the countries have been ring-fencing their markets from the volatility.

The present interest rate hike after nearly a decade begins an end to the prolonged policy of liberal monetary policy. Having been used to the abundant liquidity for many years, different economies will experience the crunch in different measures. The impact could be on domestic currencies, foreign fund flows and many more due to the interconnectedness of financial markets.

Why the impact?

In a globalised financial system, the domestic financial resources and foreign financial resources combined together decides the size and depth of financial markets that paves way for investment and growth. The movement of cross border investments is a function of interest rates and arbitrage opportunities.

More so, the interest rates prevailing in large economies like US decide the pattern of international flow of funds. Logically, funds will be invested in economies where the interest rate arbitrage is better with a low country risk. Any rational investor will look at (a) Interest rates (b) appreciation in valuations in investments (c) country risk rating (d) reciprocity and diplomatic ties.

Quantum of overseas investments

According to the World Investment Report - 2015 published by the United Nations Conference on Trade and Development (UNCTAD), inward FDI flows to developing economies reached their highest level at $681 billion with a two per cent rise during 2014. Developing economies thus extended their lead in global inflows. China became the world’s largest recipient of FDI.

Among the top 10 FDI recipients in the world, five are developing economies including India. The low level of incremental flows to developed countries persisted in 2014. Despite a revival in cross-border mergers and acquisitions (M&As), overall FDI flows to the group of developed economies declined by 28 per cent to $499 billion.

They were significantly affected by a single large-scale divestment from the United States. But India is on a sound-footing with its surging forex reserves currently hovering around $353 billion dollar, but with the hike in US interest rates, there could be flight of forex resources putting more pressure on exchange rates.

For example, the outflow of overseas funds from India during December 2015 so far has been $498.2 million, the second highest among BRICS countries. The highest foreign money of $715 million went out from Brazil and $489.4 million from South Africa. Indian rupee breached Rs 67 to a $.

Since all types of financial markets are integrated, any demand on foreign exchange could impact money supply and increase in money supply can potentially decimate the inflation glide path that India is determined to pursue.

But with the US reassuring and affirming its gradualist approach in moving towards harder interest rate regime, emerging markets including India can look forward for a seamless transition to the new economic order. The rising overseas confidence on the Indian economy can help it to retain a preferred destination for overseas investment flows despite narrowing arbitrage as other considerations of prudence can outweigh when seen in the context of emerging markets as basket of opportunities.

By:Dr K Srinivasa Rao

(The author teaches at the National Institute of Bank Management (NIBM), Pune. The views are his own)