With Fed hiking rates, will RBI follow suit? – The Hindu BusinessLine

The Federal Reserve’s resolve to adhere to aggressive policy rate hike cycle over the next couple of years is likely to create more pressure on the RBI to increase the interest rates in India.

India has been a laggard as far as rate hikes in 2018 are concerned. This has been resulting in foreign portfolio outflows from debt, thus dampening the rupee.

Empirical evidence however shows that rate hikes are not always effective in controlling the exchange rates. Experts are also divided on this.

FOMC in September

The FOMC sounded quite optimistic about the state of the US economy and cited that as a reason for moving the Federal Funds rate to a range of 2.00 per cent to 2.25 per cent on Wednesday.

With this hike, the Fed has hiked the interest rates thrice in 2018 and there is growing expectation of another rate hike in December. Further, the FOMC projections indicate at least 3 more 25 bps rate hikes in 2019, followed by one 25 bps hike in 2020.

The Fed is also continuing its balance sheet reduction that began last October. The FOMC has directed that reinvestment of maturing treasury securities will be restricted to the amount exceeding $30 billion from October this year. Similarly agency mortgage-backed securities will be reinvested only to the extent that the maturing amount exceeds $20 billion.

Impact of the move

The Fed’s action has a three-fold impact on Indian borrowers and investors. One, the cost of overseas borrowing will increase for Indian companies. Two, reducing the supply of paper will reduce liquidity in global markets, making financing conditions tighter. Three, rising yields in the US will cause portfolio investors to move money out of emerging market debt into US Treasury securities. This can make the dollar stronger, pushing the rupee lower. The dollar index moved up from 94.2 to 94.6 following the Fed’s decision.

Rate hikes by emerging economies

Other EM economies have been preparing for a higher interest rate regime in the US by raising domestic rates, in a bid to support their currencies. For instance Indonesia has hiked its key policy rate by 125 basis points since January, to support the Indonesian Rupiah that is down 9 per cent against the dollar so far in 2018. Similarly, Philippines has hiked the policy rates by 100 points, even as the Peso lost 8 per cent against the dollar this year.

The 50 basis points rate hike by the RBI so far this year is lower than the move by many other central banks. But the opinion is divided about the effectiveness of interest rates in checking currency depreciation.

Mixed impact

Empirical evidence shows that it is hard to establish a link between interest rate hikes and exchange rate moves.

In a research paper of IGIDR titled ‘The Relationship between Interest Rate and Exchange Rate in India” Pradyumna Dash, writes that the East Asian currency crisis and the failure of high interest rates policy to stabilise the exchange rate at its desirable level during 1997-1998 have challenged the credibility of raising interest rates to defend the exchange rate.

He writes that high rates can, in fact, have a negative impact on currency. “High interest rates imperil the ability of the domestic firms and banks to pay back the external debt and thereby reduce the probability of repayment. As a result, high interest rates lead to capital outflows and thereby depreciation of the currency.”

Indranil Sen Gupta of DSP Merrill Lynch, India too thinks that rate hike to control the rupee’s fall might not really help. According to him, “we cannot rule out an October RBI rate hike to ‘support’ the INR. RBI rate hikes, however, typically hurt INR as FPI investments in equity, at $500 billion, are 8x of FPI of debt. RBI tightening has succeeded only once – 1998 – of the 3 times.”

Dhanajay Sinha of EMkay Global Financial Services thinks that RBI may leave the policy rate unchanged in the upcoming October policy (in light of temporary decline in CPI inflation) but he anticipates two more hikes before the end of FY19. He maintains the possibility of INR/USD touching 75 in the near term.

Published on September 27, 2018

via With Fed hiking rates, will RBI follow suit? – The Hindu BusinessLine

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s