Fed rate hike: US action will slowdown FPI flow to India; RBI will have to shield rupee as currency might get weaker

The the US Federal Reserve was expected to increase rates this time and hence the 25 bps hike was not really a surprise. However as it comes just after the RBI raised the red flag on inflation and increased the repo rate, it becomes even more significant. While the RBI targets CPI  inflation when fixing the repo rate, the other considerations are in the area of what other central banks are doing. The related concerns are currency, foreign investment flows and global liquidity. All these factors come into play as they come back to affect inflation and growth which is within the domain of the RBI’s policy sphere. It is against this background that the Fed rate hike and the prospects of further rate increases should be viewed.It can now be assumed that the Fed rate would end at between 2.25-2.5 percent by December with two more rate hikes being announced in the next 6 months. Such action is definitely not directly related with RBI decisions but has deep implications for us. The transmission chain can be elucidated here. When the Fed increases its target rate all interest rates move up which means that lending rates of banks as well as security yields of both the government and corporates would tend to increase. A high interest rate environment is useful for investors who normally weigh the returns in various countries before deciding on where to invest. It may be remembered that when the Fed went in for quantitative easing after bringing down interest rates to close to zero, emerging markets made sense to investors as interest rates were higher. This led to a mass migration of funds to the emerging markets with all of them benefiting from the same.Now a reversal would take place and on an incremental basis there would be less of a rush to the emerging markets. This will lead to a slowdown in the Foreign Direct Investment (FPI) flows to India which are already in the negative terrain. The RBI has been proactive in widening the scope of operation of FPI in the debt market and has also removed some restrictions on their investments in terms of tenure of residual maturity of securities. While this was timed well to provide a boost to the corporate debt market, this countervailing force of Fed rate hike will make the Indian market less attractive.[caption id="attachment_4495283" align="alignleft" width="380"]

Representational image. Reuters[/caption]A reason put forward by the Fed for increasing rates is that inflation is a threat due to higher fiscal spending and tax cuts. Now with government spending on infra, a lot of private investment would also increase which will cause funds to be diverted here. This means that there is potential for FDI flows to slow down to India from the levels of $60 billion which were witnessed in the last couple of years. Therefore, on account of both FPI and Foreign Direct Investment (FDI), there would be a slowdown in flows.Fed rate hikes enter our domain once again when External commercial borrowings (ECBs) are involved. The RBI has been relaxing the norms for borrowing form the ECB window to make it easier for corporates to fund their projects. Now with interest rates rising in the west, the base rate which is used for reckoning loans, LIBOR would also tend to increase which will make it less attractive for borrowers. Hence, funding from this route will slow down. India has been getting around $ 30-35 billion on a gross basis through this route, which will come down as companies would prefer domestic borrowing.Alongside, NRI deposits too could sway as returns on deposits in the home country would be better and hence can compete with the rates offered by the Indian banks. This has been a useful source of funding the balance of payments especially in times of crisis and hence would at the limit get affected with these rate hikes.With these factors working in consortium, the balance of payments would be under strain which will lead to the rupee to get weaker. This tendency will be reinforced by the external factor which has been playing the currency market where the dollar has been strengthening against all currencies. Therefore a weaker rupee would be the next problem to confront for the RBI which will have to intervene in extreme volatile situations to cool the curreny. While the precise impact may not be very large, it would matter in the overall scheme of things.Finally the weaker rupee would also enter the inflation number via the imported inflation route and affect policy – again this may not be very significant but at the margin can add to inflation.It is for these reasons that the RBI monitors closely the developments in other central bank actions as it does have a fairly wide ranging impact on various economic variables. It does look like that the balance two hikes are almost certain given the trajectory of the growth and inflation. As the external balance can weaken it is imperative that the RBI is on constant guard.(The writer, chief economist, CARE Ratings, is author of 'Economics of India: How to Fool all people for all times')