25 Nov 2015 18:43 IST

India can survive a Fed interest rate hike just fine

From a macroeconomic perspective, India's balance of payments will help it weather the storm

The parlour game on Dalal Street has started again. Questions such as whether the US Federal Reserve will raise interest rates at the next Federal Open Market Committee Meeting (FOMC), how it will affect the Rupee, its impact on India’s trade balance and domestic inflation are popping up in everyone’s minds.

Not that the game really ever ended for it to start. It has been going on, and off, eight times a year because this is how often the powerful FOMC meets. This is the group of the seven unelected governors of the Fed which decides the value of the US dollar by setting interest rates. It also makes decisions about the money supply – how much additional money to print and how much money, already loaned out, it wants returned to it.

For seven years now, since the dawn of the US financial crisis, triggered by cheap money, the Fed has decided to keep interest rates at zero. This action is unprecedented during the last 44 years, since the world’s major countries decided to set the value of their currencies by fiat, in effect, abandoning the gold standard. Senator Rand Paul of Kentucky, an ardent critic of the Fed, said it best when he recently said: “Interest rates are the price of money – we shouldn't have price controls on the price of money”.

Looking up

Fed supporters have said that ZIRP (Zero Interest Rate Policy), coupled with Quantitative Easing, were both required because the US faced a huge liquidity crisis in 2008. Banks were running out of cash and financial markets were about to ground to a halt. In 2009, US unemployment rates were the highest since the Great Depression of 1929. For nearly 42 months straight, the overall unemployment rate in the country was higher than 8 per cent – a level unseen in modern history. Only since October 2012 has the unemployment rate dropped below 8 per cent. Last month’s rate of 5.0 per cent, supporters say, is proof that the Fed’s monetary policies have worked.

The Fed has indicated that because inflation in the US is still low, raising interest rates now may be the right thing to do. Should this happen, it is likely that the dollar will rise relative to other currencies.

Power of the dollar

However, if the Fed were a small player in world markets, its actions globally would not be quite as consequential. But the supply of US dollars still drives international trade, invoicing and settlement. Most commodities worldwide (oil, gas, soybean, wheat) are priced, sold and bought in US dollars. According to the Bank of International Settlements, the dollar was on one side of 87 per cent of all international trades in 2013. The price of dollars has an outsized impact on the nations of the world – which is why Dalal Street is worried.

That said, from a macroeconomic perspective, India should do fine this time around.

Strong and growing

India’s balance of payments is largely dictated by the country’s oil imports. With oil hovering at $50 per barrel and likely to stay at this price point in the foreseeable future, a rise in the value of the dollar is not as bad as when oil was at $110 per barrel just two years ago.

Other commodity prices worldwide are taking a beating with the near building-out (and slowing down) of China’s economy. Iron ore was selling for $189/tonne in 2011. Today, it sells for $57 a tonne, a 70 per cent price drop. Gary Shilling, an investor in commodities and currencies, wrote in Bloomberg last month: “It seems the price of everything that is grown or pulled out of the ground – from oil and gas to sugar and copper— has declined 46 percent since early 2011, causing bankruptcies and industry consolidation”.

He cautions that further big declines are possible. “As long as market prices exceed marginal cost, more (not less) production is encouraged to make up for lost revenue. Some producers will raise output even when prices fall below marginal costs.”

In a curious twist, India’s infrastructure projects, if priced and contracted right, ought to now cost a lot less today, greatly softening the impact of a pricier dollar.

Also, at the core, India’s economy is strong and growing. Many countries around the world would gladly trade their growth rates with India’s, which is forecast to be more than 7.0 per cent for next year. Like the US, India’s economy is largely dependent upon domestic consumption and not on exports – a model that makes India less vulnerable to the whims and fancies of global markets. India is a big export machine too and a slightly lower Rupee will make its services exports even more competitive. Diaspora remittances will increase as the huge and growing Indian populations abroad seek arbitrage opportunities with the exchange rate.

Money out of India

With a rise in the price of the dollar, some investor money will leave India for sure. But these investors - mainly hedge funds - were only concerned about short-term returns, taking zero interest money from the Fed to make speculative investments in India. As the price of money goes up, these hedge funds will look elsewhere to invest. But realistically, where would they put money into? Russia? Brazil? China? Europe? Pakistan?

So, let the “Will they or won’t they?” Fed parlour games begin. For 99.99 per cent of India’s population, I feel, life will go on just fine.

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