Will Fed lift off lead to emerging markets crash?

The monetary policy reversal in the U.S. is likely to be slow and even tentative, involving only moderate hikes

For the first time since 2008, the Federal Reserve of the U.S. has increased the key policy rate — Fed Funds Rate — by 25 basis points, ending its unprecedented extra loose monetary stance that had begun in the wake of the global financial crisis. In the lead up to this eventuality, the Fed prepared the financial markets in a calibrated and careful manner. By all indications, the monetary policy reversal in the U.S. is likely to be slow and even tentative, involving only moderate hikes. Three more rate increases of 25 basis points each are expected during 2016. It will, therefore, be more appropriate to term this as normalisation of interest rate, and not tightening per se.

One very distinguishing and hence important backdrop of the commencement of a cycle of higher policy rates in the U.S. is provided by the fact that with the exception of Bank of England, the current monetary policy stance in major economies such as Japan, Eurozone, China, Australia and Canada is either expansive or neutral. One can add India to the last-mentioned category.

‘Shock and awe’

Some analysts have sought to draw a parallel between Fed’s action this week and its surprise rate hike by 25 basis points in the first week of February, 1994, followed by three more increases in as many months. The ‘shock and awe’ of those steps were like a sledgehammer slamming the global financial markets, chiefly debt securities whose prices fell significantly. However, the trade-weighted exchange rate index of the U.S. dollar continued to move in a relatively narrow range well into the third quarter of 1995. The U.S. dollar’s steep rebound in August 1995 had significant implications for India: The rupee, whose exchange rate vis-à-vis U.S. dollar was largely stable since April 2003 came under intense pressure and the ensuing volatility continued into the early months of 1996.

At its lowest point during this period, the rupee had declined by over 15 per cent. The decline of the rupee also engendered substitution of foreign credit by domestic credit, which put pressure on domestic liquidity and interest rate. The developments of those two years can provide some guidance now.

‘Fed taper tantrum’

Ever since the summer of 2013, when the rupee had fallen sharply in the wake of the so-called ‘Fed taper tantrum’, the RBI has been uncomfortable about the prospects of a swift policy reversal in the U.S. In RBI’s view, reverse flow of capital in the wake of such reversal could have adverse implications for both India and the U.S. Since the normalisation of rates in the U.S. is likely to be slow-paced and in line with market expectations, the impact for India’s financial markets over the near term will be modest and drawn out. Research from Institute of International Finance lends support to this conclusion.

However, as with the currencies of many emerging market economies, vulnerability of the rupee will increase. The relative attractiveness of the yields on the U.S. government securities vis-à-vis those of other major economies, like Germany and Japan will increase in the period ahead. Not surprisingly, the U.S. dollar is on a rising trajectory, a trend, which is very likely to continue in 2016. Unlike in 1994, when the real exchange rate appreciation of the rupee was under check because of the U.S. dollar’s relative stability against other major currencies, the situation now entails a real appreciation of the rupee. Given this, and also keeping in mind that the capital inflows are already on a declining trend, depreciation of the rupee to 70 to a U.S. dollar and beyond is a strong possibility in 2016.

Corporate debt

An aspect that will impinge on the exchange rates of currencies of emerging market economies is the high indebtedness of their corporate sector, fuelling growth in recent years. Emerging market corporate debt has doubled since 2008 and it is close to 105 per cent of aggregate GDP.

The debts in foreign currencies, especially those denominated in U.S. dollar will now become more expensive to service as also to refinance. In India, the quantum of external debt repayable in one year is currently high at about 55 per cent of foreign exchange reserves.

Neither RBI nor the market has any hard data on the extent to which Indian corporates have hedged the currency risk on their external debt, including those contracted through overseas structures for being infused as equity into infrastructure projects.

Apart from causing vulnerability to balance of payments, higher cost of servicing external borrowing will lead to still higher NPA of banks. A collateral damage of a quantum jump in NPA is that transmission of monetary policy will be impeded more.

The U.S. dollar being the dominant cross-border banking and investment funding currency, a low interest rate regime in the U.S. means higher risk appetite and vice versa. With interest rate rising in U.S. and dollar appreciating, the waning of risk appetite will mean lower prices of stocks and bonds in emerging market economies, including India. However, some offsetting influence will likely be cast by ‘carry trade’ flows from countries pursuing accommodative monetary policy — Japan, Eurozone and China.

Macroeconomic policy-making and management in India will be more challenging than now. Resumption of trend growth in the U.S. is a positive for India, provided the exchange rate of the rupee is right. So is the fact that crude oil price is most likely to remain soft in the foreseeable future.

Yet, high food and service sector inflation have the potential to derail the target consumer inflation trajectory compatible with the current monetary policy stance. The risk of ‘frontloading’ interest rate cuts in anticipation of a fall in inflation and inflationary expectation by RBI in recent months may turn out to be high. All in all, interest rates in India are unlikely to fall further in 2016.

In conclusion, the Fed hike will not mean a rude shock for emerging markets, including India. But the end of a prolonged era of easy money in the U.S. will likely bring to the fore pre-existing vulnerabilities.