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Monday, December 28, 2015

Fed Has at Last Raised Interest Rates: A Threat to Emerging Markets?

Janet Yellen, the Fed Chair, has finally raised short-term interest rates by 25 basis points from the historic lows it occupied ever since the US was hit by the worst financial crisis in the modern times in December 2008. The current increase comes amidst the news of steady recovery in the US economy, duly supported by the growth in consumer spending, while inflation remained steady at 2 per cent, which is well within the Fed’s goal, and the unemployment rate stood at 5 per cent. 

Future increases are expected to be gradual, as indeed the Fed Chairman took all the pain to explain that Fed’s policy stance would remain “accommodative”, of course, based on the assessment of “realized and expected” economic conditions vis-à-vis employment and inflation rates. No doubt, this move of Fed is certain to influence the markets, but for the time being, the markets appeared to have reacted pretty calmly. However, the big question remains: Will the markets remain sanguine if the Fed continues with its cycle of interest rate hike?

Looking at the fact of global growth being still lacklustre and importantly, Fed’s counterpart in EU is still pursuing an easy monetary policy, a section of economists are wondering if Fed’s move to raise the interest rates is right. Interestingly, the research report of the Office of Financial Research indicates that the ultra-low interest rates that prevailed over almost a decade have considerably distorted the financial system. If this is true, the calm reaction of the markets to the current rise in interest rates needs to be watched carefully. For, the credit bubbles that the decade-old low interest rates created across the global financial system may deflate, resulting in a contagion in the credit risk of banks. It does not however mean that the current rise is wrong—it is indeed, overdue—but it only calls for exercising caution both by the Fed and the markets: both should behave in sync.

Now moving on to the emerging markets, it must be said that if the Fed continues to be on interest rate tightening trajectory during 2016, as indeed it indicated in so many words, it would certainly impact the emerging markets’ interests. For, the first reaction would be the reverse flow of the capital of nearly $9 tr that accumulated as debt in the emerging markets fuelled by the US easy money policies. This—the flight of capital from these markets—is sure to harm the interests of emerging markets in two ways: one, cause a deep credit crunch, and two, result in increased corporate-defaults, which means, increased cost of capital/high debt service costs.

Of course, this effect may not however be uniform among all the emerging markets. Countries such as Brazil, Indonesia, Russia and South Africa, which are overexposed to foreign debt owing to their rising fiscal deficits, are likely to be more impacted by this phenomenon. Corporates from these countries that have borrowed heavily in dollars but earn income mostly in domestic currency are likely to be the worst sufferers as rising dollar interest rates might lead to its appreciation.

That said, emerging markets must also watch how China is going to respond to the rate changes. For, it poses an altogether different challenge: its monetary policy being not in alignment with the Fed’s, analysts believe that it is likely to cut its benchmark interest rate, at least twice during 2016. The proposed fall in interest rates vis-à-vis dollar interest rates coupled with the outflow of capital from China is sure to create pressure on Renminbi. Should this happen, Renminbi is all set to depreciate against dollar in 2016. As the history reveals, there will be no surprise if such depreciation of Renminbi leads to currency wars among Asian countries, besides causing disturbances in the global commodity markets.

Now, turning to India, the big question is: What does all this mean for India? It definitely poses a challenge to the Indian policy makers. They, looking at the initial reaction of the market to the just announced increase in interest rates, should not be complacent. Instead they should tighten the measures to ensure that fiscal deficit and inflation remain within acceptable levels. Particularly, policy makers must focus on the mounting bad debts in the banks coupled with the weak balance sheets of Corporates—about which the RBI Governor has already voiced his concern—and put suitable measures in place before they slip out of control. Though the stock markets discounted the rate hike coolly, further hikes are likely to trigger volatility. Nevertheless, we are better placed in this regard vis-à-vis other countries.  Rupee is likely to depreciate further, but this may augur well for our exports growth, but the corporates must be agile enough to quickly encash on it.

In the ultimate analysis, what is more important for India is to ensure that its growth plans are not derailed. And to address it, the political parties must shed their narrow interests and join hands to roll out the necessary reforms well in time so that our businesses can compete more effectively. Else, the nation must get ready to pay a huge penalty. 


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