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  • How US Fed’s rate hike can impact India

    Publish Date: September 27, 2018

    The US Federal Reserve’s expected benchmark interest rate hike on Wednesday will have ramifications for the Indian economy.

    The US Fed boosted the lending rate from 2% to 2.25% — this is the eighth such hike since late 2015. Expectations are the Fed may introduce further rate revisions in December and three more in 2019, raising the specter of strong capital flight from India.

    So, let’s understand how a hike in US lending rates can affect the Indian economy.

    1) Capital flight

    Increase in lending rates always brings in “hot money” to the economy. “Hot money” means expatriation of funds to another country with a higher interest rate.

    The Fed’s decision to increase lending rates will result in higher yield on US treasuries. Indian bonds, on the other hand, will become less attractive when compared to its US compatriots. This is why investors can pull their money out from Indian bonds and move to the US market.

    Since the Indian economy has been volatile of late due to a host of internal and global factors, the US bonds have become even more attractive for foreign investors.

    2) Weaker rupee

    The Fed rate hike will also make the dollar stronger. As a result, India’s rupee is expected to slide further.

    A weak rupee is bad news for the Indian economy at the moment.

    The US rate hike does not come at the best of times from India’s perspective, given the soaring global crude oil prices. A high oil import bill, compounded by fuel subsidies to the public, can result in fiscal slippages in the coming months.

    Also read: Fuel prices on fire: The what, why, how and what now

    3) Rate hike in India

    India’s central bank is also considering raising lending rates in India in the October 4-5 meeting. The rate hike may keep Indian bonds competitive for a while, and keep foreign investments intact.

    Also read: Related read: Why RBI is likely to hike lending rates in October

    But in the long run, such liquidity-tightening measures may affect the country’s growth. Large and small businesses, including startups, would feel the pinch as raising investment would become expensive. The difficulty in raising capital to expand business can consequently impair asset valuation and balance sheet of companies.

    4) External debt pressure

    Strong capital flow will keep the Indian markets on the edge because the economy is reliant on foreign currency debt.

    India’s external debt crossed half-a-trillion dollars in March 2018 because more companies borrowed money from overseas markets. Since the rupee has depreciated by around 12% since the start of the year, Indian companies will have to repay a higher loan amount in absolute terms. A State Bank of India report suggests that the Indian economy as a whole will have to cough out an extra $9.5 billion to meet its short-term debt obligations in the coming months.

    5) Gold price

    A stronger US bond can lead to a fall in gold price. Although there is no conclusive data to suggest an inverse relationship between US interest rates and gold price, the popular opinion is that gold prices usually tumble when US lending rates are increased. That’s because US bonds and fixed income instruments become a more attractive investment option than gold.

    As a result, investment portfolio of millions of Indians will be rocked because large swathes of the population invest in the yellow metal. As per a Reserve Bank of India report, around 11% of the population have put their money on gold, as against just 2.9% of people who have invested in financial assets.

    Also read: What high current account deficit means to investors

    To sum up, the lending rate hike will impact the Indian economy. Currency depreciation, ravaging trade wars, rising crude oil prices and contagion fears, can play their part to sap the economy.

    However, the Indian government can afford to wait and watch. That’s because it has ample foreign exchange reserves to cushion capital outflow for the next eight months or so. And secondly, the US Fed seems to be raising rates to consolidate US’ growing economy. It understands that quick-silver rate hikes would harm the US economy for now.

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