The long awaited suspense over the US Fed rates were finally lifted when Janet Yellen announced a 25 basis points hike in the Fed rates on 16th December. After keeping Fed rates in the range of 0-0.25% for almost 7 years since the Lehman crisis in 2008, the Fed finally decided to move the rates up to the range of 0.25-0.5%. Interestingly, this is the first time since 2006 that the Fed is attempting a rate hike. In these 10 years global financial markets have become a lot more integrated and global monetary policy has got much more aligned. It is in this context that the rate hike needs to be understood.
The rate hike could impact India in a variety of ways and there are four critical aspects to understand. The most important thing to understand is that the uncertainty is over; and financial markets hate uncertainty. That is the good news. Having said that, these are early days and the real impact may actually play out in the days to come. In the past, a rate hike has been accompanied by capital outflows from emerging markets and India too has paid the price of that. Back in mid-2013, the moment Ben Bernanke started talking of a market taper, FIIs pulled nearly $13 billion out of Indian debt. This not only led to the Nifty crashing but also led to the rupee crashing to the Rs.68 mark.
Implications for capital flows into India
We believe that capital flows into India may not overly impacted due to the rate hike in the US. Firstly, the rate differential between India and the US is very important. Currently, the rate differential between the US 10-year G-Sec and the equivalent Indian 10-year G-Sec is almost 550 basis points. This is fairly higher than the median spread of 4.3% over the past few years. With this kind of spread, debt investments by FIIs are unlikely to flow out in a big way. We would like to believe that the $4 billion of outflows that we have seen since September could largely account for the outflow fears.
On the equities front, the real story will be the Indian GDP growth, which is likely to scale 7.6% even by conservative estimates. With the market correcting by almost 18% from the peak of March 2015, the margin of safety is back and the downside risk is limited. Hence, the risk of an equity sell-off also may not be too pronounced for India.
Impact of a strong dollar
This is a real problem that India will have to contend with. The higher Fed rate will lead to a strengthening of the dollar and a consequent weakening of the rupee. This impact may get more pronounced as China also makes efforts to devalue the Yuan. This could have two implications. Firstly, import intensive industries like capital goods and oil marketing companies may see their dollar liabilities rising; at least to the extent they are not hedged. The bigger problem could be for FCCB borrowings and there are a lot of infrastructure companies in this list who are already under financial stress. These companies could take a real hit if the dollar appreciates sharply.
We, however, do not expect this impact to be too steep on the markets as a whole. During the last year, the RBI has managed a calibrated depreciation of the rupee without creating any tumult in the forex markets. This will ensure that any sharp currency shocks are avoided.
Remember, a rate hike is a signal of growth…
That is probably, the most important take-away from the rate hike story. A rate hike in the US implies three things. Inflation is back to a higher plane, unemployment is at a low and GDP growth is picking up. Inflation is a debatable point as cheap oil and commodities have kept inflation subdued. These are market driven factors and individual nations will have limited control over inflation. However, it is true that unemployment in the US is down to 5% and that is the lowest in 40 years. Secondly, despite growth pangs in EU, Japan and China, the US continues to maintain 2-3% GDP growth and looks set to achieve 4% growth in the next couple of years.
A rate hike at this point of time is, therefore, a signal that the US economy is in fine fettle and is poised to grow much faster. That by itself is good news for the global economy. When an economy with an annual GDP of $18 trillion gives a positive growth outlook, the spill-off effects can be huge. For India, that could be an important takeaway, especially for sectors like IT and Pharma which are predominantly dependent on US demand.
Do rates really matter?
Finally, the question is, do rates really matter to markets. An empirical analysis done by Russell Investments proves that they actually don’t. According to the study, over the last forty years, rate hikes and rate cuts by the Fed have not really resulted in any substantial impact on equity market returns in the US or other markets over the medium to long term. The study additionally notes that equity markets the world over have typically benefited when the Fed cuts rates rapidly or increases rates gradually. Since the Fed plans to have a calibrated rise in rates from here on, India and other emerging markets may actually have a lot to cheer.
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