Is the US Federal Reserve’s decision this week to pause its short-term rates a source of relief for the Reserve Bank of India (RBI), or does it signal a potentially larger concern on the horizon that the RBI is downplaying? The current situation is certainly less than ideal, with geopolitical uncertainties looming large over the financial markets.
With the US Fed’s short-term interest rate at 5.25-5.50 percent and India’s benchmark rate at 6.50 percent, the interest rate differential between India and the United States has narrowed to a historically low level of just 125 basis points. This situation does not encourage foreign investors to take risks and invest their funds in emerging markets like India at this moment.
Ghazal Jain, Fund Manager at Quantum Mutual Fund, remarks, “The ‘higher for longer’ stance should keep markets on edge.”
In fact, this phrase was used by US Fed Chair Jerome Powell to emphasises the necessity of controlling inflation to the Fed's 2 percent target. The Fed aims to avoid the mistake of prematurely lowering rates, which could fuel another surge in inflation. The Fed has made this error in the past and is now more cautious.
Chief Economic Advisor (CEA) V Anantha Nageswaran, however, believes that the RBI is unlikely to face significant pressure to tighten its monetary policy in response to any further interest rate increases by the US Federal Reserve. He said this in a recent interview. But as things stand today, the interest rate differential between the US Fed rate and India's repo rate has narrowed quite a bit.
The current situation of persistently higher interest rates in US and other developed markets introduces external risks, as these elevated rates are already contributing to higher yields and a stronger dollar index, making the US market more attractive to investors.
Let’s examine the changes in the external landscape, which could have adverse implications for the domestic market.
Over the past three months, US 10-year treasury yields have increased by about 15 percent, rising from around 4 per cent in August to 4.63 per cent in November. The dollar index has also strengthened by over 6 percent, increasing from 100 to 106 levels. The consequence of this can be seen in the outflow of dollar funds from the Indian stock market. Foreign portfolio investors sold (net) stocks worth Rs 13,810 crore in September and Rs 17,875 crore in October, with outflows of Rs 1,302 crore recorded in November first week. In addition, the outflow of foreign funds has contributed to depreciation of the rupee by 60 paise over the last three months.
There is also no respite from rising crude oil prices, as Brent crude prices have surged from USD $82.73 per barrel in August to $86.85 per barrel. This rise in crude oil price is not transffered to retail consumers as the oil marketing compaies have to adjust it with earning lower margins because of upcoming state elections."The cost would be borne by the state owned companies otherwise the higher prices would have pushed the inflation higher,"says an analyst.
While CEA Nageswaran's assessment may hold true if the geo political situation stabilises, there is a risk of spillover effects if the external environment continues to weaken. Forex reserves have decreased from a peak of USD $642.4 billion in September 2021 to $583.5 billion in October of the current year. "It's a policy choice. We are maintaining lower interest rates at the expense of rupee depreciation and utilizing forex reserves," says a market participant.
In fact, central banks in Indonesia and the Philippines have already initiated increases in short-term interest rates. Bank Indonesia raised the policy rate by 50 basis points to 5.25 percent this month. Similarly, the Philippine central bank hiked the benchmark interest rate by 25 basis points to 6.5 percent in an off-cycle meeting.
Pankaj Pathak, Fund Manager- Fixed Income , Quantum Mutual Fund says that despite geopolitical uncertainties and high crude oil prices , India has a very comfortable current account position, reasonably high economic growth and falling underlying inflation trend. "The RBI also holds a strong war chest of foreign exchange reserves which can be used to stabilise INR if need arises. I think all this provides the RBI some degree of freedom to conduct monetary policy based on domestic factors and overlook the interest rate differentials with the US at least for time being," says Pathak. He , however says that it would be difficult for the RBI to cut rates if the US fed continues to hike or keep rates elevated.
Madhavi Arora, Lead Economist at Emkay Global Financial Services, suggests that the Fed has left the door open for additional rate hikes, even though Powell didn't defend the September commentary, which implies another hike in December.
According to Motilal Oswal Financial Services' currency report, the dollar index is expected to trade with a positive bias, with resistance at 107.30 and 108.20, and support at 105.30 and 104.50. It states, "With lingering inflation concerns in the market, the Fed is keeping the door open for further rate hikes."
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