The whole world was waiting for news about the US Federal Reserve’s ( American Central Bank) decision to hike interest rates. After 10 years, the Fed announced on December 16 a rate hike of only a quarter percentage point (0.25). It is the first hike since 2006. The anticipation of the rate increase had already created turmoil in all Emerging Markets including India. In recent weeks preceding the hike, the stock market in India fell sharply as Foreign Institutional Investors (FIIs) moved back to America where the attractiveness of the bond market and the security of investing in the US have returned. The dollar has been going up against the rupee as a result and at the same time oil prices have reached the rock bottom of $38 per barrel. Clearly the US seems to be the best bet for investors amidst falling commodity prices.
In November alone, $1.15 billion worth of FIIs moved back to the US from India and sold $552 million in domestic debt. The rupee’s fall against the dollar has been cushioned by the RBI which has been entering the market and selling dollars from its reserves to maintain the value of the rupee at a reasonable level.
These recent events clearly show how deeply India has got integrated in world financial markets since the financial crisis of 2008. As a result of the loose monetary policy that involved very low interest rates and ‘monetary easing’ that the Fed followed, the US economy is now on a recovery path and on the employment front there has been an increase in jobs at an average of 237,000 jobs a month for the past 12 months. The unemployment rate has gone down to 5 per cent.
The Federal Reserve had deliberately kept the interest rate at near zero level to encourage investment and help economic recovery. It embarked on ‘quantitative easing’ in December 2008 which meant about $4.5 trillion were released in the financial system over the last few years. The quantitative easing ended in October 2015.
There are only two countries in the world which are growing in a sustained manner today -- One is the US and the other is India. Because US economy is an advanced and rich one, the rate of GDP growth for economic revival that is required is much lower. Hence the US GDP growing at 2.5 per cent has been hailed as a ‘strong’ rate of recovery. For India the rate of growth required to bring the 350 million or more people out of poverty is around 6 to 7 per cent. India has indeed experienced a higher rate of growth in the last quarter of 7.5 per cent and is expected to grow at 7 to 7.5 per cent next year also.
The ‘gradual’ raising of US interest rates will obviously mean that US will attract more FIIs. In the last few years the FIIs were involved in ‘carry trade’ meaning that they borrowed from a low interest country like the US and invested in risk assets of Emerging Market (EM) economies’ debt and equity markets. The margin for carry trade will be lower with the lifting of US interest rates. Meanwhile the returns from investment have also gone down in EMs –hence FIIs would prefer to remain in the US because even with lower margins, it is better for them to be in the safe environment of the richest country in the world.
But mass exit of FIIs will mean a loss of liquidity from the Indian market for which Mr. Raghuram Rajan has insisted that he is well prepared. The RBI has Liquidity Adjustment Facility which allows commercial banks to sell securities through reverse repo rate operations to enhance liquidity. The reverse repo rate is 100 basis points ( 1%) below repo rate at which banks borrow from the RBI. It will also conduct open market operations in which RBI will buy government securities and release enough liquidity in the market.
India needs to remain on a high growth path and it has to find its own channels of financing the much needed infrastructure projects. FDI is therefore a better option than FIIs though India has benefited from the mass inflow of FIIs in the past years as it provided the financial markets with much required liquidity. While FDI is stable and involves transfer of technology and knowhow, the FIIs keep floating from country to country in search of higher and higher returns.
For India to have 7.5 per cent growth will not be easy. Fortunately the industrial growth was high at 9 per cent in October but the November IIP is not very encouraging at 4 per cent. Exports are down for the last one year consecutively by 24.4 percent. Inflation is up when measured by the Consumer Price Index and is at 5.4 per cent. One may predict that RBI is unlikely to reduce interest rates further in the next RBI policy review which is not good news for encouraging investment. The rupee may depreciate further which will be good for exports though the RBI may try to stabilize the rupee so that imports do not become too costly. Otherwise the advantage of falling oil prices will be nullified.
Though US rate hike may signify a rise in demand for exports from India one must note that the yuan has also devalued by 4 per cent in August and has depreciated (1.3%) further in recent weeks. The hike in interest rates in US will mean a bigger debt burden for the Indian companies which have borrowed abroad liberally in the past few years. In the face of high interest rates prevailing in India the RBI had eased the External Commercial Borrowing norms which allowed private and public sector companies to borrow abroad.High interest payment component of financial outgo will cut into the profits of companies which have been languishing in the last one year because of weak demand.
Filling the gap left by FIIs will not be easy. The banking reforms are urgent for the public sector banks which have to become more efficient in dispensing credit to business.
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David Rusnok Researcher Strengthening National Climate Policy Implementation (SNAPFI) project DIW Germany
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