In recent years, the actions of advanced country central banks produces strong impacts on the financial market conditions of emerging market economies like India. For example, a possible interest rate hike by the US Fed (the central bank) is expected to bring down stock prices and rupee weaker. Governor of RBI, Raghuram Rajan asked the Fed to consider the effect of the Fed’s actions on emerging markets.
Developed countries in the past had adopted the easy money policy. Here the central bank reduces interest rate and expands money supply. Objective of this strategy is to encourage people to take more loans so that consumption and investment activities are increased. If consumption and investment expenditure are increased, it will help economic growth.
But on the contrary, often, the availability of funds in countries like the US is taken by the investors to invest in other countries like India where the return is high. An attraction of emerging market economies is that the share prices and bond yield are relatively high and economies have high prospects. Because of this trend, whenever the US Fed Reserve adopts an easy money policy like the just concluded quantitative easing, foreign investment into India increases. For example 2002- 2007 is now known as a major period of easy money policy by the US. During this period, net foreign investment into India increased from $ 10.6 bn in 2002 to $106 bn in 2007. As a result of the financial crisis, net capital inflows was a meager $6 .2 bn in the next year.
The period of 2002-2007 is known as the period of global excess liquidity (due to easy money policy by the US Fed).
After the crisis, from 2008 onwards, the US has adopted further unconventional monetary policy. This was a higher degree of easy money policy. This phase was featured by extraordinary way of reducing interest rate and increasing money with the banking system through the famous quantitative easing programme (QE). Quantitative Easing is a programme where the Fed reduces the interest rate in the economy indirectly by buying large quantity of government and corporate bonds. During the third phase of the QE (known as QE 3), the US Fed has decided to continue the bond purchase programme till interest rate reaches 2% or unemployment coming below 7%. The Fed has purchased $80 bn value of bonds monthly thereby expanding money supply and reducing interest rate.
By October 2014, the Fed started slowing the QE by reducing the monthly bond purchase amount. This is called tapering. Now the Fed think that the unemployment rate has came down to below 5%. Hence, the Fed is expected to increase its policy rate or short term interest rate (like the repo rate in India). An increase in interest rate is essential because it is risky to continue the low interest rate policy for a long term. It may produce adverse effects as well.
Effect on India
An increase in interest rate by the Fed, will increase the overall interest rate structure in the economy as well. Higher interest rate may lead to higher yield for government securities as well. This will encourage US investors to invest in the US as the return from the US becomes more attractive.
The general expectation about the after effects of US Fed’s rate increase is that significant capital outflows may occur from EMEs like India.
Foreign investor’s especially the US based investors’ investment in Indian share market and bond market will decline. Hence steep decrease in stock price may happen. Similarly, with many Investors exiting Indian bonds, the bond yield may increase. Besides, exit of foreign investors from India may cause depreciation pressure on Rupee’s value.
But in the medium term, the financial market and rupee may register strength as many foreign investors deciding to return to India. This is because; India is the ‘bright spot’ in the world economy. Another trend is that the European central bank has decided to launch their QE with the winding up of the US QE. Hence, the instability in the Indian market may be settled soon.
In conclusion, an advanced country central bank like the US Fed’s decision can influence the financial market situation in EMEs like India. Lower interest rate of easy money policy by the Fed encourages capital inflow into India- causing appreciation of rupee and stock price rise. On the other hand, higher interest rate by the Fed may encourage capital outflow from India- bringing decline in stock prices and value of rupee.