Wednesday, 09 Oct, 2024
By: Anshul Vipat
The US's actions come as many other countries also raise rates in response to their own inflation problems, which have been fuelled by a mixture of factors, including higher energy prices as a result of the war in Ukraine.
The latest hike, particularly the US one will have a negative effect on emerging markets like India, where the capital inflow will be disrupted, and the national currency will be weakened against the strong US dollar
The US Federal Reserve has raised interest rates by 0.75 percentage points as it continues to battle the worst outbreak of inflation in 40 years. The latest increase takes the bank's benchmark lending rate to 3.75 percent - 4 percent, a range that is the highest since January 2008. Federal funds rate is the interest rate at which commercial banks in the US lend their excess reserves to each other on an overnight basis.
The US's actions come as many other countries also raise rates in response to their own inflation problems, which have been fuelled by a mixture of factors, including higher energy prices as a result of the war in Ukraine. In the UK, the Bank of England raised interest rates by three-quarters of a percentage point on November 3, to 3 percent, after consumer price inflation returned to a 50-year high in September. The rate increase is the Bank of England’s eighth in a row and biggest since 1992.
The latest hike, particularly the US one will have a negative effect on emerging markets like India, where the capital inflow will be disrupted, and the national currency will be weakened against the strong US dollar. On September 21, the US Federal Reserve hiked its policy rate by 75 basis points (bps). On that particular day, the Indian rupee slipped to a record low of 80.86 against a US dollar as compared to its previous day's close at 79.97. This was the biggest single-day decline in the value of the rupee in seven months.
American effect on Indian rupee
Due to high interest rate capital flows more towards the American economy. When the US Federal Reserve increases the interest rates, the dollar rises, subsequently attracting foreign investors to invest in US assets and the stock market in order to get better returns. This scenario tends to further push the dollar up in value. The recent hike will widen the gap in interest rates between India and the US. Therefore, foreign investors will be tempted to withdraw from Indian markets. Thus, increase in US interest rates has a direct effect on foreign institutional investor (FII) outflows in India.
As money flows out of India, the rupee-dollar exchange rate gets impacted, depreciating the rupee. So far in September, FIIs have already sold ₹2,806 crore including equity, debt and hybrid assets. Data from the Centre for Monitoring Indian Economy (CMIE), showed that Foreign institutional investors have pulled out over Rs 1,75,000 crore in the first nine months of 2022 itself. This is almost equal to what they brought between 2014 and 2020. This also affected the foreign investment flows. FDI tapered off sharply in 2022.
If we take a close look at the chart above, we will see an upward tick in August. This was when the rupee largely remained stable. However, the situation changed in October leading to a slump in Indian currency. From Rs.79.92 per US dollar on September 21, it depreciated to Rs.82.4 per US dollar on October 7. The exchange rate had averaged at Rs.79.68 per USD in the first three weeks of September.
Past patterns suggest that a hike in US interest rates is usually matched with a hike in Indian interest rates. This is justified because domestic inflation is high and the Monetary Policy Committee (MPC) of the RBI tries to rein in inflation through interest rate hike like the US Fed does in the US.
The Fed has increased the rate by 75 basis points four times since June. On the other hand, the Reserve Bank of India (RBI) has hiked the policy repo rate by 190 basis points since April. So far in 2022, the RBI has hiked the policy repo rate four times, US Federal Reserve has also increased the interest rate thrice so far this year. However, the Fed has been more aggressive in hiking interest rates when compared with the RBI. The cumulative increase in interest rate by the US Fed is 300 basis points or 3 percent. To sum up the economic slump in US, the interest rate in the country was almost zero at the start of the year.
Woes to increase
Despite US central bank increasing interest rates, the country's inflation rate refuses to slow down. US retail inflation for September remained high at 8.2 per cent. Inflation in the US has persisted at a 4-decade high. According to experts, a hike of another 75 bps in interest rates in the next meeting of the US Fed in December is almost certain. This is expected to lead to another round of FII outflows, and, consequently, rupee depreciation. This will likely force RBI to notch up interest rates in its December meet. This will further put pressure on the INR/USD exchange rate.
Consequently, the pressure on rupee is unlikely to ease in the near future. Easing of the trade deficit and sustained high capital flows are the only two factors that can help reverse the current weakening of the rupee. But this seems unlikely in the near future. And India won’t be the only country affected by this. Increase in US fed rates impacts larger emerging economics such as Brazil, South Africa and even Turkey.
Impact on you
Such depreciation puts considerable pressure on the already high import price of crude and raw materials. India currently imports 85 percent of its oil demand and the rise in crude oil prices directly increases import bill and expenses. All this leads to inflation, and a depletion of our forex reserves because we’re sending out more dollars on crude oil. The inflation rate continued to breach RBI’s comfort zone of 2-6 percent for the ninth consecutive month. On the other hand, retail inflation has galloped to a 24-month high in September at 7.8 percent.
Apart from crude oil, New Delhi is also heavily dependent on fertilizer imports and fertilizer subsidy is set to hit a record high. Organic chemicals, machinery items, electronics and pharmaceuticals, labour-intensive exports like textile may also take a hit.
