The Fed rate hike now looks closer and surer than originally anticipated. Janet Yellen had identified 3 critical factors which could impact the decision to hike rates. She called for a pick-up in GDP growth, fall in unemployment to 5% and inflation above 2%. The GDP has surely shown signs of picking up in the US. The rate of unemployment has been falling consistently since 2009 and is now close to 5%. Inflation is still below 2% due to the effect of cheap oil, but that may not be a sustainable rate. If the recent statements of Janet Yellen are to be taken at face value, then a rate hike may actually come as early as September this year.
A rate hike means tight money and tight money has never been great news for the economy. However, in the case of the US there are two additional features. It is a major source of portfolio flows into other countries and prints the currency which is the largest constituent of global currency reserves. This makes the problem slightly more complicated. Let us understand how this trend could impact India in the medium term, assuming that the Fed does hike rates in September.
A stronger dollar will imply a weaker rupee
One of the obvious outcomes of a rate hike would be a further strengthening of the dollar. If you look at the dollar index over the last one year, the DXY has already appreciated from a level of 81 to 103 before settling below the 100 mark. A rate hike could once again take the DXY above the 100 mark. A weak rupee will be negative for India in two ways. Imports will get costlier and this is a serious problem since India runs an annual trade deficit in excess of $125 billion. A weak dollar will also force FPIs to delay their India portfolio investments since it makes a lot more sense to invest in rupee assets closer to the bottom.
A risk-off trade could be a major worry for India…
To be fair, a risk-off trade has already started. As the Greek crisis began to unfold, we could see the money flows into US bonds and German bunds as they are considered safe-haven assets. However, low to negative yields has been a major bottleneck for both these asset classes. A rate hike will improve the yields on these bonds and force a rush of money into these assts. In fact, the experience in the past has been that FPIs tend to sell out of emerging market debt to invest in developed market debt, whenever there has been a rate hike. India did see that happen in 2013 and that is surely a situation that India would like to avoid.
What about the mountain of dollar debt…
The non-US world has a mountain of dollar debt in excess of $1 trillion. India too could find itself in a mess with a dollar debt in excess of $100 billion. More importantly, over 50% of this debt is un-hedged and is extremely vulnerable to a spike in the US dollar. Many infrastructure companies that have un-hedged dollar debt are already struggling to service their debt. A rate hike, as we have seen earlier, will strengthen the dollar and make the situation for the dollar borrowers worse. The condition of these companies could really worsen if the dollar goes into a sustained upswing.
Company valuations could see a downgrade
This is a slightly more difficult one. One of the reasons many companies in India have enjoyed high P/E ratios despite slow growth is the low interest rates. A company value is a function of two key factors viz. future earnings growth and the discounting factor. Even if growth stagnates the cost of capital goes down when rates are falling. That is exactly what has happened since 2008. A combination of too much liquidity and low rates has enhanced equity value even though growth has not been great. With a rate hike, bond yields will move upwards and the cost of capital will also go up resulting in lower P/E ratios. This can have a fairly large impact on stock prices, especially sectors that are quoting at high P/E ratios.
RBI will have a policy dilemma
A key impact of the Fed rate hike will be that it will put the RBI in a policy dilemma. On the one hand, there have been demands from industry to cut rates. A rate hike by the Fed will force the RBI to rethink on rate cuts. A rate cut will make rupee debt less unattractive as compared to dollar denominated debt. This may force the RBI to put off rate cuts for the time being. With credit flow down to a trickle, the RBI will have a trying to convince the finance minister why they can’t cut rates. As for industrial credit, that will surely take a back seat.
In a nutshell, a rate hike by the Fed could have serious implications for India. One hopes that the Fed may reconsider its decision to hike rates due to pressure from the American exporters. But for a nation that has long focused on a strong and resilient dollar that may not exactly be the prime consideration.
You can ask us your stock related questions with #AskReligareOnMarkets via our Twitter channel @religareonline