Last Wednesday, the US Federal Reserve cut its key interest rate by 0.5 percentage points for the first time in four years. That was done to prevent the sub-prime mortgage crisis and the housing bubble from developing into a full-scale recession.
In August, the first shadow of recession had already become visible with the loss of 4,000 jobs. Ben Bernanke, Chairman, Fed, therefore went one step ahead of the market which was expecting only a 0.25 percentage point cut in interest rates. Usually, a rate cut takes about 3 to 9 months to ripple through the economy and boost activity. The impact of a hefty cut, like the present, may take lesser time.
The cut in interest rate by Fed instantly kicked up share prices not only in the US but in most other countries. That is because with cross-border investments there is greater integration of markets and generally prices in different markets move together except when they are primed entirely by domestic factors. No wonder, the Sensex reached a new peak when the BSE opened on Wednesday after the Fed rate cut.
The interest rates are similarly harmonized subject to the differential risks. A cut in interest in one country gives rise to arbitrage opportunities with investors borrowing in the cheaper market to lend in the dearer. For that reason, the cut in interest by Fed would divert some of the US funds to other countries to take advantage of higher returns. A part of this outflow will find a perch in India for investment in deposits, bonds and shares. Further, Indian investors will be tempted to borrow overseas subject to the new regulations of the RBI.
Two outcomes of Fed rate cut are most likely. First, there will be an upward pressure on the rupee; and second, there would be a downward pressure on our interest rates. Already the dollar has fallen below Rs.40 for the first time in nine years and, with the expected larger inflow of dollars, will fall further unless the RBI effectively intervenes in the currency market. If this is not done, the strong rupee will make exports difficult and imports and foreign travel more attractive.
The other outcome would be an excess surge of liquidity in the economy which can drive interest rates down and inflation up. The RBI consequently will increase CRR (the balance banks have to keep with the RBI), or take other measures to drain out the excess money unless inflation remains stable at less than 4 per cent. The RBI in that case may reduce the rate of interest since there are signs that the rate of growth of industrial production has halved in the last one year.
The cut in the Fed rate will create some problems for India mainly because we will be saddled with unwanted dollars. It is not desirable to put restrictions on the inflow but it should be possible to increase the outflow by making rupee more convertible for Indians.
The writer is president, RPG Foundation