A week after the Reserve Bank of India (RBI) chose to keep interest rates unchanged, the US Federal Reserve, the central bank of the US, jacked up interest rates by 25 basis points (bps) and decided to unwind its balance sheet, which is bound to impact the Indian markets and the rupee. With the US tightening its policy stance step by step, the big question is: Will US Federal Reserve chairman Janet Yellen’s move force the RBI to cut rates in the August monetary review?
This is the Fed’s third rate hike since December and signals that the US economy is getting stronger. The US central bank has increased its benchmark interest rate by a full percentage point over the past two years, after leaving the rate close to zero from late-2008 to late-2015. The new range will be 1-1.25 per cent for a rate that currently is 0.91 per cent. On the other hand, the RBI, which has kept the benchmark repo rate steady at 6.25 per cent in the last four policy reviews awaiting the US Fed decision and the progress of monsoon, could perhaps opt to go for a bigger cut.
Emerging market (EM) equities and currencies have turned in a mixed performance in the last quarter, with high valuations across Asia, but weaker in Latin America on softer commodity prices. The Sensex.
Gained 22.2 per cent, or over 5,700 points, in the last one year, aided largely by huge inflows by foreign portfolio investors (FPIs). While bond yields in major advanced economies have been largely range-bound, in EMs, yields have hardened in the few countries facing inflation pressures and political uncertainties, but for commodity exporters, there has been some recent decline. Huge FPI inflows also boosted the rupee by 4.45 per cent to 64.30 levels in the last one year.
With the Fed tightening the policy and indicating more hikes later this year, it remains to be seen whether foreign investors will be keen to invest in India and other emerging markets as they used to do through most of 2016. With rate differential between the US and India narrowing, they may prefer to stay invested in the US. The Fed has announced that it will unwind its $4.5-trillion balance sheet, or portfolio of bonds including Treasury bills, mortgage-backed securities, etc., which was picked up during the quantitative easing phases. According to the statement, the balance sheet normalisation plan would feature halting re-investments of maturing securities so as to cut balance sheet levels appreciably below those seen in recent years but larger than before the financial crisis. The reduction of balance sheet size would mean withdrawing liquidity which will have an impact on the flow of funds to the EMs, including India.
India has been a beneficiary of these flows in both the FDI and FPI spaces. FPIs invested Rs 54,369 crore in calendar 2017 so far, taking the Sensex to a new peak. The debt market also received huge investments to the tune of Rs 86,851 crore in 2017. The equity market is more likely to be impacted as the inflows in the debt segment have been buoyant this year. “With US interest rates moving up and domestic interest rates bound southwards, there would be a tendency for funds to remain within the domestic frontiers of the US. While the RBI has stated that monetary policy would be targeting domestic inflation, such developments would definitely play out in the background as the external account would also tend to be under pressure if there is any reversal of flow of funds,” said a CARE Ratings report on the impact of the US Fed move.
However, bankers and markets were expecting a rate hike by the US Fed. “The markets have priced in at least three hikes this year. So, it can be said that this is in line with expectations. Even if there is a knee-jerk reaction, we expect markets to recover quickly within the same/next few trading sessions,” said Prasanth Prabhakaran, senior president and chief executive officer, YES Securities.
The RBI will also be mindful of the Fed impact on the rupee and the overseas borrowings. While the strong rupee has resulted partly from a strong capital account where investment flows have steadied the balance of payments, the dollar will tend to appreciate which will put pressure on other currencies and the present tone of a weak dollar will get reversed over time. This will also have an impact on the US trade balance. “On the other side, several developing countries have debt in dollars. The appreciation in the dollar will increase the cost of dollar repayments and increase the share of debt paid for by emerging economies,” said CARE Ratings.
Besides, as Europe’s “macros” and political environment continue to improve, Analysts expect that the European Central Bank could begin normalising policy by the end of 2017 or early-2018. As money moves to Europe, the dollar index (heavily weighted by the euro) would tend to lose. “For the dollar-rupee pair, it means that the upside potential is rather limited in the near term. With the ongoing weakness in the dollar, we do not expect the rupee to breach 65.50-66.00 levels this year. In fact, the appreciation scenario for the rupee, which we earlier anticipated to begin by the end of this year could initialise much earlier,” said Abheek Barua, chief economist, HDFC Bank.
Wholesale Price Index-based inflation has fallen to a low of 2.17 per cent, growth has dipped in the fourth quarter of fiscal 2017 and industrial production is down — factors signalling a rate cut by the RBI. Before the August policy review, goods and services tax (GST) will also be implemented and the RBI will also get an idea about monsoon. “We point out that the rate differential with the US Fed remains comfortable at almost 500 bps, even if the Fed hikes again in December. In fact, in the last upcycle, the RBI ran a 150-200 bps gap with the US federal funds rate. Even factoring in a lower import cover, the RBI should be able to cut rates by 25 bps,” said Indranil Sengupta, India chief economist, Bank of America Merrill Lynch.
When the US tightens the money policy, it could be time for the RBI to turn more dovish and bring down the rates.