AI Insights

US Fed Rate Hike: How does it affect India?

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This post has been authored by Aniket Raj, the Economic Research Intern at Arthashastra Intelligence.

In a highly globalized world, whatever happens in one part of the world, the impact is visible across the globe. And when that part is the USA, it is bound to impact the emerging economies.  If we see the recent rate hike decision by the Federal reserve, we will find that it was the most significant rate hike by the central bank of the USA after 1994 to tame its runaway inflation. This can be seen from the graph below.

These rate hikes adversely impact emerging economies. In this data story, we will look at the potential impact this rate hike possesses on the Indian economy, an emerging economy.

1. FPI Outflow- The first and the major impact will be on foreign portfolio investment. If we look at the trends, we find that foreign portfolio investors have pulled out 42,000 crores only in June amid monetary policy tightening in the U.S. If we see the graph above, we find that the U.S has started increasing its fund rate in 2022 and FPI outflows in 2022 till June has been around 218,000 crores. This pullout is creating a negative impact on the sentiments of equity and forex markets.

2. Weakening of Rupee- With the unabated foreign outflow, the rupee is depreciating faster. This year itself, it has depreciated by 5 percent against the dollar. The growing uncertainty in the world due to war and an increase in fund rate has made the capital flow move from emerging economies like India to a safe haven like the U.S, strengthening the dollar further. This weakening of the rupee has increased the borrowing cost of companies through external commercial borrowing routes. Recently, it was one of the major sources of funds to finance the project as the interest rates were lower.

3. Widening current account deficit- The current account comprises two things: trade account and invisible account. Trade account refers to the import and export of goods; invisible account refers to the import and export of services. If a country\’s export is greater than its import, it is known as the current account deficit. India also has a current account deficit. An increase in rate hike results in a depreciating rupee, which will lead to an increase in the cost of imports hence increasing the current account deficit. Also, the increased cost of imports will lead to imported inflation as it will increase the burden on retail prices.

4. Loss of real disposable income- As a result of an increase in the Fed rate, R.B.I has also increased its interest rate, which will lead to higher debt servicing costs. Debt servicing cost is the total cash required to pay the debt obligation. The increase in interest rate increases the cost of funds, increasing debt servicing costs. This will lead to an erosion of real disposable income. The erosion of disposable income means that the customer’s purchasing power parity is decreasing, which is not a good sign for the economy that is still recovering from covid shocks.

5. Uncertain growth prospect- Increasing the fund rate by the U.S will reduce the interest rate difference between India and USA and hence will affect the flow of risk capital leading to tighter financial conditions. Also, the erosion of real disposable income and the widening of the trade deficit hurts our growth prospects. The increase in interest rate by R.B.I as a counter to the Fed rate hike will increase the cost of funds. This will affect our capital expenditure which, as the government mentioned, will be the driver of our economic recovery.

With speculation of a further rate hike by the USA, R.B.I. and the government need to fasten their seatbelts to ensure macroeconomic stability in the country, as our economy is still recovering. The government should strengthen our domestic institutional investors as they are the ones who will absorb the shock which foreign portfolio investors will create by selling.  Though the weakening of the rupee will lead to costlier imports, it will also make our exports more attractive, and the government needs to increase the exports to reduce the gap between imports and exports.

During the efforts to form United Nations, Winston Churchill once said, “never to let a good crisis go to waste”; this fits well with the current situation of the Indian economy.

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