What an increase in Fed rates would mean for India

As money flows out of India, it would affect the exchange rate, weakening the rupee and putting considerable pressure on the already high import prices of crude and raw materials.
Image used for representational purpose only. (File Photo)
Image used for representational purpose only. (File Photo)

The US Federal Reserve Bank (the Fed) has raised interest rates by 25 basis points on Wednesday, after more than three long years. The last time the Fed raised interest rates was on 18–19 December 2018, by 25 basis points, announcing the target range for inflation to be within 2.25–2.5%. After that, the Fed continuously cut rates in 2019 and 2020. The last cut of 100 basis points was announced after an emergency meeting on 14–15 March 2020, which brought the target rate to 0–0.25%, thus setting into motion a two-year period of near zero rates. Such near-zero rates were aimed at giving the US economy the ability to recover from the coronavirus pandemic and have lasted two years. The rate hike on 15–16 March 2022 has brought the interest rates within a target of 0.25–0.5%. Further, the Fed has announced a total of seven hikes throughout 2022.

The reasons for the proposed hike have to do with the ‘Dharma’ of the Fed, like any central bank, which is to maintain economic and financial stability, monitored typically through measures of inflation and unemployment. Thus, when output falls, unemployment rises and the economy looks like it is slowing down, the Fed would go slow on its interest rates, even bringing them down to near zero levels as it did during the pandemic. Such policy measures will encourage businesses to invest more, given the low rates of interest. At the same time, it would also encourage consumers to borrow more at lower rates and spend more, thereby encouraging production growth and employment in the economy. The reverse is expected when the economy begins to get heated up, leading to inflation.

The US has been experiencing boiling prices, with inflation levels touching a 40-year high of 7.5% on an annual basis in January 2022. This was compared to its previous figure of just 1.4% in the same month the previous year. The inflation rate likely to prevail by the end of 2022 is estimated to be 4.3%, which is way above the 2% annual target set out by the Fed. The seven interest rate hikes proposed would then increase US short-term interest rates to 1.875% by the end of 2022, with the benchmark rate rising to 2.8% in 2023 following four additional hikes.

How will higher Fed rates impact India Inc.?

The Fed rates impact Foreign Institutional Investments in emerging markets like India. Higher rates of interest in the US would lead to a pulling out of these investments (also called portfolio flows) from India. FIIs have been estimated to have sold more than $29 billion worth of shares in the fiscal year 2021-22 so far, with more than 80% sale happening between October 2021–February 2022. Just to get a sense of the problem, the cumulative Foreign Portfolio Investments (FPI) flow in fiscal 2021 was $3.76 billion, which has been more than offset by the FPI outflow of $4.6 billion in January 2022 alone.

As money flows out of India, it would affect the rupee-dollar exchange rate, depreciating the rupee. Such depreciation would put considerable pressure on the already high import prices of crude and raw materials, paving the path for higher imported inflation and production costs besides higher retail inflation. The Wholesale Price Index Inflation at 13.11% indicates the constraints on the supply side for India Inc. On the other hand, retail inflation at 6.07% in February 2022 has already breached the upper limit of the range (2–6%) set out by the Reserve Bank of India two months in a row. Higher inflation beyond the tolerance band will pose challenges to India’s economic recovery as India Inc. may find itself not having sufficient pricing power to pass on such costs.

There is another route through which such inflation will bite India. The fiscal deficit numbers of 6.9% of the GDP set out in Budget 2022 are based on an oil price of $75 per barrel. Higher import prices of crude would send these numbers out of range, making government borrowings costlier, as also increasing the public debt to GDP ratio. Such a high debt to GDP ratio has been the reason for the decision of the credit rating agency, Fitch, to maintain India’s sovereign credit rating at BBB- with a negative outlook. According to Fitch: “India’s public debt/GDP ratio, at about 87% in FY21, is well above the median of around 60% for ‘BBB’ rated sovereigns.”

An increase in US Fed rates, thus, will affect the cost and also the availability of overseas finance for Indian companies. They have been looking at cheap overseas finance amid these near-zero rates to fund their capital needs, as Indian economic activity picks up. Thus, Indian companies have borrowed medium and long-term funds through external commercial borrowings to the extent of $31.17 billion between April 2021 to January 2022, with $20 billion coming from only 5 months. There would be considerable constraint on such financing needs as Fed rates are hiked. Moreover, with government borrowing rates increasing due to the poor rating of Indian sovereign debt, the rates at which the private sector can borrow abroad will further increase.

India Inc. needs to monitor the global macroeconomic situation and its impact on its bottomline to be able to proactively withstand some of the external-induced shocks.

Tulsi Jayakumar


Executive Director, Centre for Family Business & Entrepreneurship at Bhavan’s SPJIMR

(The author is also a professor of economics at the institution. Views are personal)

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