Interest rate hikes coming to the US: Why India should brace itself

  • Gaurav Choudhury, Hindustan Times, New Delhi
  • Updated: Mar 19, 2015 11:26 IST

The US Federal Reserve on Wednesday ended it's pledge to be "patient" and hinted at the possibility of interest rate hikes this year, the first time in nearly a decade. Analysts expect the first rate hikes to come in by as early as June.

HT takes a look at how high interest rates in the US could impact India:

What has the Fed Reserve done?

It has hinted at plans to hike interest rates from near zero levels for the first time since 2006.

What has prompted this move?

The US economy has shown strong recovery signs over the last few months. Central banks across the world use monetary tools to stymie demand and cool prices. In times of weak growth and low prices, they keep rates artificially low to goad companies to invest, add capacities, hire more, and prompt people to spend on houses, cars and other goods. When growth returns, they raise interest rates. With budding recovery, the US central bank thinks that higher interest rates will not upset the economy's revival.

When will interest rates rise in the US?

The first interest rate hikes are expected by June this year

What does an interest rate hike mean for India?

An interest rate hike in the US could trigger a dollar flight from emerging countries such as India. A rate hike in the US will encourage foreign, particularly US-based funds, to move money out of India to safer locations closer home.

Why will funds move money out of India?

Global funds park money based on expectations of yields. With short-term rates ruling at near zero for nearly a decade, India and other emerging markets offering higher returns were the preferred hotspots. With US interest rates set to rise in the US now, most funds may prefer to move money out of these markets.

What would be the immediate impact for India?

A dollar flight out of the country, if sudden and copious, can trigger a fall in equity markets and hurt the rupee’s value. Like any other commodity, the exchange rate or price of a currency is determined by the laws of demand and supply. A stronger demand for the currency will push up its price and vice versa. So, dollars moving out would mean higher demand for dollars, pushing up the US currency’s value against the Indian rupee. Having said that, the dollar flight will unlikely happen immediately. It will likely happen only once interest rates start rising in the US, which analysts believe is not going to happen until June.

What’s in it for the economy?

A depreciating rupee will make imported goods costlier. So, if the rupee falls, expect computers, imported mobile phones and gold to become costlier. It could also negate the gains of low crude oil prices, prompt oil companies to hike petrol and diesel prices. Costlier transport fuel will knock up prices of most goods and stoke inflation. A weak domestic currency affects the current account deficit — the gap between export earnings and import payments.

Should I be worried?

You better be, if you have plans to study and travel abroad. A weaker rupee implies you end up paying more to buy dollars to pay for your fees, even though the fee in dollar terms remains unchanged. So, your study loans might go up.

What about foreign travel?

If you were planning to an overseas vacation, you better set aside more money A weaker rupee implies you end up paying more to buy dollars to pay for your air tickets, hotel tariffs, shopping and other expenses. Even though the tariffs in dollar terms remains unchanged, a lower rupee could force you to buy more foreign exchange before you head out for the vacation.

What about exporters?

If you are exporter, a weaker rupee would mean your earnings in rupee terms will go up. But slowdown in EU, India’s biggest export market, may force orders to dry out.

How will it affect companies?

A possible slide in rupee will hurt profitability of many companies. Companies that borrowed dollars from overseas banks will be the worst hit as repaying loans will become costlier. Imported raw material such a copper, aluminum and machinery will turn costly and squeeze profit margins. This may prompt companies to raise prices of consumer goods such as cars and televisions.

What policy options are used to stem the rupee’s fall?

As the country’s central bank, Reserve Bank of India (RBI) has a responsibility to prevent economy from currency shocks. Central banks world over intervene through buying or selling of currencies through banks. To prop up a weak rupee, the RBI sells dollars in the market. India's forex reserves are at a record high of over $320 billion. This would give the RBI enough elbow room to enhance dollar supplies and arrest the rupee's fall if the need arises.

What about interest rates?

In the eventuality of a persistent fall in the rupee's value the RBI may be hesitant to cut interest rates to maintain India’s attractiveness as favoured destination for foreign funds and bring in dollars to stem the rupee’s fall. But, this could hurt companies’ investment plans, keep EMIs high and slowdown the overall economy’s recovery.

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