logo

Implications of latest Fed hike

Implications of latest Fed hike
At long last the US Federal Reserve – America’s central bank—has raised the interest rates, albeit hardly. It is the first hike in interest rates by the US central bank in over a decade.

The hike in interest rates has been marginal – from zero to just about 0.25 percent to 0.5 percent. Suffice to say, the rate hike did not cause great disruptions in the global financial markets.

However, how will it affect India? It should not, and such a fact has been borne out by what happened in the day after the Fed rate hike. The stock market remained more or less flat. The exchange rate also remained stable. Fund managers did not immediately think of taking money out of India, leaving the financial markets unruffled.

Why should a decision of the US central bank matter so much for India? To appreciate the gravity of such a question, a little background is required.

Following the 2008 global financial meltdown, the world economy had gone into a recession. To lift the economy certain measures were needed. The US, which remains a significant player in the global economy, had taken key steps. One of those steps included cutting its interest rates in stages to zero. When the cuts in interest rates did not result in the desired lift, it had launched an unconventional monetary measure, now known as the Quantitative Easing (QE).

QE was simply pushing more money into the US financial system to encourage overall demand and activity. In effect, however, a lot of the QE funds had flown from the US to other countries in their stock and bond markets. The flow of funds had paid for the excess imports of countries over their export earnings, besides strengthening their exchange rates. Recipient countries had become used to cheap funds from the US.

Now before, the Fed had stopped QE. And on December 16, the Fed raised its interest rate from zero to positive for the first time in a decade. This was long expected –almost for a year. Fed had had also given an indication that rates might be raised again in the course of the coming year. By taking such measures, what Fed is doing is bringing its unconventional monetary policy from an “abnormal” stance to a more “normal” stance. However, why should a gradual shift in the Fed’s monetary policy create such expectations and fears among other countries?

This question is relevant because of our experience when the previous Fed Chair Ben Bernanke had announced his decision to “taper” bond purchases by the US central bank. That decision had caused a huge uproar in financial markets across the world. At the time and in the subsequent months, the Indian rupee had depreciated from Rs 50 to a dollar to over Rs 60 to a dollar.

Tapering of bond purchases meant that lower funds will be available and, as a result, part of the funds flowing to other countries could be pulled out and, at least, fresh flows restricted.

Known now as the “taper tantrums”, the string of events across the world showed the power of the dollar in the wake of the global financial crisis in 2008. The taper tantrums hit India hard in 2013 because of its dependence on overseas funds flow. India was then running an uncovered high current account deficit – of around $88 billion.  The fiscal deficit was high, inflation rising –almost everything wrong was rising.

Today India’s external deficit was minimal, under 2.5 percent of the GDP; we have a fairly comfortable foreign exchange reserve and inflation low. Oil prices are low, gold imports have plummeted (which was fiercely rising then). We do not depend abjectly on funds flow from to finance our imports and meeting external dues.

Many other currencies, including the Brazilian peso, South African rand and the Russian rouble had faced the same fate during the subsequent months after that announcement and volatility continued for a year. US Fed’s rate rise had ended one major uncertainty for the global economy. The inevitable has happened and all the financial markets have discounted this in this interconnected world. But then, a new uncertainty has cropped up. China’s economic footprint has enormously increased since the days of global financial meltdown and the deepest source of volatility and uncertainty stems from that country. During that period of uncertainty, the Chinese yuan remained rock strong and China made its tentative move to make the yuan the next reserve currency. China had extended yuan credit lines to a large number of countries for use during exchange rate volatility. This time round, the Chinese yuan had however depreciated – although rather marginally. It depreciated by only one-tenth of 1 percent. But that hides more than it reveals because the Chinese authorities grossly intervene in the market to stabilise its currency.

Chinese authorities had depreciated yuan in August and that created a stir among many other countries since China had emerged as a major importer and countries have become somewhat dependent on their exports to China. Many countries, including China, Brazil, and Argentina had seen a spate of fluctuations in their financial markets.

From the uncertainty over Fed rates hike, the fear has moved to what the Chinese will be doing and how their economy was behaving on the ground. China is admittedly slowing down. It even officially expects the Chinese economy to grow much slower by 6.5 percent this year from over 7.5 percent target. But then, the fear is, maybe, China is slowing down much faster and possibly to a crisis level. 

(The views expressed are strictly personal)
Anjan Roy

Anjan Roy

Our Contributor help bring you the latest article around you


Exclusive

View All

Latest News

View All
Share it
Top