The US Fed Rate Hike Will Affect India, But RBI Needn’t Revise Monetary Policy Just Yet

Though India will be affected and the rupee may weaken, comforting levels of foreign exchange reserves will likely soften the blow. Emerging economies with high external debt measured in US$ will suffer more.

A man walks past the US Federal Reserve in Washington. Credit: Reuters/Kevin Lamarque

A man walks past the US Federal Reserve in Washington. Credit: Reuters/Kevin Lamarque

Earlier this week, the US Federal Reserve (the Fed) raised its policy rate known as the federal funds rate from the range 0.25%-0.50% to 0.50%-0.75%. This increase comes after 12 months.

There have been expectations for a while that the recession which broke out after the 2008 financial crisis could be fought with loose monetary policy. It is widely known that the Fed and the Democrat president could not succeed in persuading the Republican-dominated legislature to agree to expansionary fiscal policy measures of public expenditures. The neoliberal policies of less government, no budget deficits and less public debt combined with monetarism was ruling the roost. It was left to the Fed to be the ‘Lone Ranger’ in the fight against recession.

Quantitative easing by pumping several trillions of dollars into circulation debased the currency. Steady outflows of US capital to emerging economies depreciated the US dollar, no doubt contributing to reduction in its own annual trade deficits by making its exports cheaper to the rest of the world.

Short-lived optimism

With recovery in sight in early 2015, though painfully slow with small monthly increments in job numbers, the Fed was finally able to get the economy out of a low interest environment in December last year. The Fed was keen to return to days of a “normal” interest rate regime as soon as there were some signs of recovery, reflected in the rising price level as well as fall in unemployment rate.

It announced its first rate increase in December 2015, with indications that it might consider two to three increases in 2016 if the recovery is firmed up, reflected in the consumer price index and the unemployment rate.

The optimism was short lived. The Brexit vote came as a jolt; fears of another phase of recession discouraged any further efforts towards tightening monetary measures. Uncertainties continued and although jobs were growing, there was no steadying trend. The time for further increasing the policy rate had not yet arrived.

Return of Keynes, but in a Republican disguise

The November 8 US presidential election results altered the scene. With the Republican president-elect announcing that he would embark on fiscal policy measures of investing one trillion dollars in infrastructure projects, tax cuts for encouraging corporate investment and regulatory rollbacks, all with an eye on job creation, the US economy began to look up.

Indeed, this heralded the return of Keynes in a Republican disguise. This was much to the dislike of hardcore party members, as it meant higher public debt than the current debt to GDP ratio of 77%. Though inflation is still low, below the targeted 2% per annum, market signals are clear. The unemployment rate is close to 4.5%, below the targeted rate of 5%. The signs of a recovery were firming up. Bond yields of different maturities were rising. The average rate on a 30-year mortgage loan went up to 4.13% from 3.54% before the election.

The Fed’s Open Market Committee, in its scheduled meeting on December 14, made the unanimous decision to increase the federal fund rate. It is a modest increase, but a significant step.

Impact on India

India will no doubt be affected. Though the rise in interest rate differential is low as of now, with indications of the possibility of a further rise in the differential due to two more expected cuts in policy rate, there are fears of increasing outflows of capital. That would weaken the rupee further, from the current rate of Rs 67.79 to about Rs 69 per US$.

Depreciation of the currency would increase the rupee value of the imports of petroleum crude oil, whose price is quoted in US dollars. Latest reports show that India’s oil demand went up in November 2016 by 12.1% from November 2015, with petrol demand increasing by 14.3% to reach 2.03 million tonnes; LPG sales rising by 16.5% to 1.88 million tonnes; naphtha sales rising by 6.9% to 1.08 million tonnes and fuel oil demand increasing by 12.6%.

Given this situation, the trade deficit in India will naturally bulge from the current 5.7 % of GDP with the increase in the Fed’s rate. If capital inflows dry up, the balance of payments may deteriorate further. However, the foreign exchange reserves remain at the comforting figure of $363,870 million.

Other emerging economies are likely to suffer more, due to very high external debt denominated in US dollars. The depreciation of currencies of Mexico and Brazil will take a heavy toll on their budgets, as they have to set aside more savings for debt servicing. India, on the other hand, has smaller external debt ratio (22.7 % of gross national income) and a relatively low debt servicing ratio (8.1 % of total exports of goods and services) compared to major emerging economies.

India’s current situation

With cash-starved rural areas and a badly-hit informal sector after demonetisation, growth prospects have been affected in the last quarter of 2016. Since this impact is likely to extend into the first quarter of 2017, there is no possibility of any demand pull inflation. The Asian Development Bank has just revised India’s growth rate in 2016 to 7%, down from the earlier forecast of 7.4%.

Inflation in November 2016 is reported to be lower (3.63% annualised) as against 4.2% in October 2016. The fears of inflation stem only, as noted by the Reserve Bank of India recently, from a possible decline in the winter crop output and rise in crude oil prices (presently hovering at around $55.16 per barrel) leading to rise in transport costs.

In these circumstances, the RBI may not need to consider any further steps to the already announced monetary policy action of December 7: the unchanged repo rate of 6.25%. The withdrawal of 100% cash reserve ratio would enable banks to disburse credit to sectors in need. Already, some commercial banks have reduced their benchmark interest rates for encouraging liquidity.

No immediate action on the part of RBI would be an appropriate monetary policy response at this stage.

T.K. Jayaraman is a professor at Fiji National University.