FED RATE HIKE–Tightrope walk | Business Standard Editorials

The United States Federal Reserve’s decision to raise policy rates for the third time in 2018 was expected. However, it will mean a perpetuation of existing trends that are becoming cause for worry for India’s central bankers and economic policymakers. The dollar is likely to continue strengthening, and dollar yields will also likely rise, given that more Fed hikes are in the offing through 2019-20. This means crude oil will become more expensive in rupee terms. In addition, the Fed is reducing the size of its balance sheet to “normalise” after a long period of quantitative easing. Higher crude oil prices and a tighter, more expensive dollar will put further pressure on India’s already high trade and current account deficits. It could also mean more domestic inflation, given that trade accounts for over 40 per cent of gross domestic product (GDP). The RBI’s Monetary Policy Committee will have to consider the possible consequences carefully. An already weak rupee could be affected by higher dollar yields, which may induce foreign portfolio investors (FPIs) to pull out of rupee debt and equity. That could have a cascading effect, where the rupee weakens even further, spooking FPIs who pare India exposures yet again.

Although the RBI has reserves of almost $400 billion, there are also substantial overseas obligations in the next 12 months. Moreover, a large proportion of reserves consists of “hot money” accrued from portfolio investments and FPIs have sold Rs 750 billion worth of rupee assets in the past six months. Large forex outflow would be unacceptable and the RBI may opt to raise the policy rates at the next policy review in early October in order to maintain the interest rate differential between the rupee and the dollar at the current level. Higher policy rates may help to protect the rupee. But they would inevitably impact consumption and reduce the volume of credit offtake. This could mean a slowdown of the nascent corporate recovery. At this instant, domestic inflation is moderate, despite higher fuel costs. That’s because the food inflation rate has eased a lot. But core inflation (that is, excluding food and fuel) is also affected by imports and it will surely rise as the rupee falls. Indeed, the recent policy of protectionism through the levying of higher import duties may add impetus to import-driven inflation.

The RBI’s task is further complicated by problems across the financial sector. Bank bad loans continue to present a huge overhang and the recent IL&FS defaults have created anxiety and fears of a liquidity crisis across the NBFC space. Obviously, higher interest rates could make things worse and may even cause a jittery bond market to freeze. Protecting the rupee against capital flight, infusing liquidity into a tight bond market, and ensuring that consumption doesn’t contract are important. Balancing such conflicting imperatives will require sensible prioritisation and a tightrope act from the RBI. However, it must be noted that this is not the RBI’s sole responsibility and this situation cannot be tackled purely through monetary action. Policymakers must find creative ways to stimulate exports in order to exploit the weak rupee and reverse the current adverse trade position.

via Tightrope walk | Business Standard Editorials

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