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US Fed is set to raise interest rate. How will it affect India?

Neeraj Thakur | Updated on: 14 February 2017, 1:15 IST

As the US Federal Reserve meets Tuesday to revise short-term interest rate, the heads of central banks the world over are keeping their fingers crossed.If the rate is hiked, the greatest impact will be felt in the emerging markets, including India, whose stock markets are likely to see an exodus of foreign institutional investors, or FIIs.

What's the hike about?

The likely hike in the interest rate has been the most talked about event in the global economy since the recession of 2008.

It has been delayed by years under pressure from economists and central bankers.

Also read: RBI's Raghuram Rajan certain of US Fed raising interest rate by up to 0.25 per cent

In September this year, the Fed delayed revising the lending rate by three months to make sure the recovery in the US economy was indeed on strong ground. The hike is expected to be anywhere up to 0.25 %.

Why is it such a big deal?

The US economy was hit by a severe recession in 2008 which eventually spread to much of the world. It bankrupted big banks, most famously the Lehman Brothers, and even nations like Greece and Iceland.

In the US, unemployment soared and consumer demand plummeted as the people had little to spend. To counter the liquidity crunch, the Fed cut down the interest rate charged on loans to banks to zero.

This gave the US banks a lot of money to lend cheaply. In turn, the people got enough cash to spend, boosting demand. The same policy was followed by the Euro Zone and the UK.

Also read: Interest rates and RBI: Your guide to understanding this complicated relationship

On the downside, the zero interest rate made for poor returns for investors who park their money in government bonds and securities of the developed countries for better, assured returns.

So the investors took their money to emerging markets, which promised higher interest rates and, thus, better returns.

Now, if the Fed raises the interest rate, the investors will return to the US market. And since both Britain and the Euro Zone are likely to follow the US' lead, the outflow of money from the emerging markets will be massive.

How will this affect India?

So ominous is the expected rate hike for the Indian market, that just its anticipation has sent the Bombay Stock Exchange tumbling in seven of the past nine trading sessions.

Further, Tuesday's hike will likely be only the first of a series. This means more investors could ditch Indian markets in the months and years to come.

Also read: Explained: Why Rupee plunged to a two-year low

In the current fiscal until November, FIIs have already taken out Rs 14,212 crore from the Indian market, the highest in the last seven fiscals.

How will it impact the rupee?

Since the hike will give investors better returns, demand for the US dollar will increase. The dollar, as a result, will strengthen. A stronger dollar means a fall in the value of the rupee.

The Indian currency has performed badly in the past year, largely due to falling exports. It touched a two-year low of 66.88 against the dollar last week.

An expensive dollar means India will have to shell out more for imports, which will erode its finances.

In 2014-15, the government spent $112.748 billion on the import of crude oil alone. India imports 80% of its requirement of crude oil, or 189.43 million tonnes last year.

Also read: India's trade with Africa is a throwback to the Raj

Another consequence of the higher cost of imports could be an increase in inflation. The consumer price index, a measure of inflation, for November stood at 5.41%. If the rate exceeds 6%, it dents the capacity of the Reserve Bank to reduce interest rates for the industry.

Loss of foreign exchange

RBI Governor Raghuram Rajan has been selling foreign exchange to arrest the fall in the rupee. Currently, India boasts of comfortable foreign exchange reserves of over $350 billion.

But the reserves could be diminished if the rate hike further weakens the rupee, forcing Rajan to sell more dollars than he would like.

Impact on start-ups?

According to Nasscom, global private equity and venture capital firms invested $2.2 billion in 179 Indian start-ups in 2014. This year, the figure is likely to touch $6.5 billion.

However, as the rate hike makes developed markets more attractive for investment, these firms will likely be less interested in the Indian start-up ecosystem.

Companies in trouble

Companies with exposure to the dollar denominated borrowings are likely to be in trouble.

RBI data shows that external commercial borrowings from March 2014 to March 2015 increased by 32% to $181.9 billion. This accounts for 38% of India's total outstanding external debt. Commercial external borrowings have grown at an annual rate 15.6% since 2008.

Worryingly, as per RBI data, only 41% of this debt has been hedged by the Indian corporates against volatility in the rate of dollar. This means that an increase in the value of dollar against rupee will increase the liability of Indian companies.

Are these fears exaggerated?

Some economists say emerging markets like India have already factored in US interest rate hikes in their economic plans. So, according to them, there won't be any significant impact when the actual rate hike is announced.

Some even say that the fear of the hike has been more harmful than the actual hike will be.

Are they right? We will know when the Fed chair Janet Yellen makes the announcement in a few hours from now.

Also read: Business wire: Inflation remains in negative territory for 13th month in a row at (-)1.99%

First published: 15 December 2015, 3:32 IST
Neeraj Thakur @neerajthakur2

As a financial journalist, his interface with the two dominant 'isms'- Marxism and Capitalism- has made him realise that an ideal economic order of the world would lie somewhere between the two.

Senior Assistant Editor at Catch, Neeraj writes on everything related to business and the economy.

He has been associated with Businessworld, DNA and Business Standard in the past.

When not thinking about stories, he is busy playing with his pet dog, watching old Hindi movies or searching through the Vividh Bharti station on his Philips radio transistor.