The US Federal Reserve recently hinted at a potential surge in interest rates, causing unease among Indian markets. The actions of the Federal Reserve not only influence the US economy but also shape the macroeconomic outlook and have a significant impact on the monetary policies of other emerging economies. We break down how this change could affect India’s financial landscape.
Co-relation of Federal Reserve & Indian Markets
Emerging economies such as India typically experience higher inflation and interest rates than developed countries like the U.S. and most primarily Western European nations. Thus, financial institutions, especially Foreign Institutional Investors (FIIs), often borrow money from the U.S. at low dollar interest rates and invest it in government bonds from emerging countries like India. This investment is made in the local currency to earn a higher return on interest.
However, when the U.S. Federal Reserve increases its domestic interest rates, the gap between the interest rates of the two countries diminishes. As a result, India becomes less appealing for the currency carry trade. This shift could potentially lead to some money leaving the Indian markets to return to the US. A currency carry trade is a financial strategy where a high-yielding currency is used to fund trade with a low-yielding currency, subsequently causing a decrease in India’s currency value against the U.S. dollar.
Impact of Increased Interest Rates on India
Effect on Equity Market
Rising interest rates can result in increasing bond yields due to a burgeoning dollar shortage in the global market. Previously, both the debt and equity markets in India experienced outflows exceeding Rs 40,000 crore due to the strengthening dollar and uncertainties triggered by trade conflicts between the U.S., China, European Union, and other major nations.
Influence on Export and Forex
As one of the world’s largest crude oil importers, India faces the challenge of a weakening rupee against the dollar making crude oil imports more costly. This price hike can induce inflationary pressures on the entire economy, notably in sectors highly susceptible to crude oil price fluctuations.
On the plus side, India’s exports – particularly those in the IT and IT-enabled services sector – could benefit from a stronger dollar compared to the rupee. However, this advantage may not be completely realized by exporters because of stiff competition in the export market.
