US Federal Reserve & Indian Market | 29 Jan 2022

Why in News

Recently, the US Federal Reserve (central bank of US) has signalled a possible hike in interest rates. This has led to a nervous reaction in Indian markets.

  • Rate hikes by the Federal Reserve affects not only the US economy, but also shapes the macroeconomic outlook and exerts a certain degree of influence on the monetary policies in other emerging economies.

Key Points

  • Co-relation of Federal Reserve & Indian Markets:
    • Emerging economies such as India tend to have higher inflation and higher interest rates than those in developed countries such as the US and many of the (primarily Western) European nations.
    • As a result, financial institutions, particularly Foreign Institutional Investors (FIIs) would want to borrow money in the US at low interest rates in dollar terms and then invest that money in government bonds of emerging countries such as India in local currency terms to earn a higher rate of interest.
    • When the US Federal raises its domestic interest rates, the difference between the interest rates of the two countries decreases.
    • This makes India less attractive for the currency carry trade, consequently, some of the money may be expected to move out of the Indian markets and flow back to the US.
      • A currency carry trade is a strategy whereby a high-yielding currency funds the trade with a low-yielding currency.
    • Therefore decreasing the value of India’s currency against the US dollar.
  • Impact of Increased Interest Rates on India:
    • On Equity Market:
      • Bond yields will rise due to growing dollar shortage in the global market.
      • Previously, in India, the debt and equity markets witnessed outflows of over Rs 40,000 crore rupees, due to the strengthening dollar and uncertainties perpetrated by the trade war between the US, China, European Union, and other major nations.
    • On Export and Forex:
      • India being one of the largest crude oil importers of the world.
      • A weaker rupee vis-à-vis a dollar results in more expensive imports of crude oil that may put cost-driven inflationary push across the whole economy and especially in those sectors that are highly sensitive to crude oil price movements.
      • India’s exports on the other hand, notably IT and IT-enabled services – will benefit to some extent from a stronger dollar with respect to the rupee.
      • However, the same benefit may not fully accrue to exporters due to strong competition in the export market.

Source: IE