CIRCUIT BREAKER. When Fed plays the waiting game

After letting global financial markets stew for many months, the US Federal Reserve developed cold feet at the last minute to leave its benchmark rates unchanged this week. Market participants are undecided if the hike will now unfold in December, or if the goalposts will be shifted once more to 2016. So assuming that the Fed will embark on a rate-hike cycle some time in the next six months, what would be the impact on India? The experts seem to be arrayed into two camps.

One set of experts and economists seem quite convinced that the US Fed rate hike will be quite cataclysmic for India. Their argument is based on the impact on liquidity or money flow into the markets.

For the past nine years, since the global financial crisis broke, the US Fed (along with other central banks) has injected prodigious amounts of liquidity into the global financial system — first via the bond buyback programme and then through near-zero interest rates, in order to stimulate growth.

Whether this has indeed stimulated growth is open to question, but this excess money sloshing around in global markets has fuelled a number of asset bubbles. The commodity super cycle of 2006-2011, the eight-year bull run in gold, large flows into emerging market equities and the mania for negative interest-earning bonds, may all owe their ebullience, at least in part, to these easy money policies. Market players fear that a hike in the Fed funds rate which will signal the official end to the cheap money party, will completely deflate these asset prices.

The Indian markets have been beneficiaries of the tide of liquidity from foreign portfolio investors (FPIs) too. After pouring $16 billion into shares last year, FPIs today own 20 per cent of all outstanding shares in the Indian market and drawf both domestic institutions and retail investors in stock ownership. With relaxations in investment limits, FPIs have become large players in Indian bonds too, investing $26 billion last year; but they own less than 4 per cent of the outstanding bonds.

Given that India runs a sizeable trade deficit and is perpetually hungry for dollars, FPI pullouts can set off a slide in the rupee. This can set in motion a vicious cycle. It can cause India’s import bill to swell and current account deficit to widen. It can increase energy and material costs and re-fire inflation. It can trigger debt-servicing problems for Indian firms who have been on a borrowing binge abroad. Weak rupee also decimates returns for foreign investors, and could prompt them to make an even more concerted dash for the exit door.

Now, it is these doomsday scenarios which seem to have prompted the RBI to hold on to its benchmark interest rates and build a large hoard of dollars over the last few months, in the home-stretch to the FOMC meeting. A domestic repo rate of 7 per cent plus may have proved enough of a sweetener for foreign investors to stay put in Indian bonds, even if they fled equities.

But the above risks have been debated so often and so shrilly in the past few months, that a few market participants have switched to a contrarian point of view too. This camp argues that Fed rate hikes will actually prove good for the Indian economy. They argue that global markets are not all about money flows and asset bubbles. What about the real economy?

Their reasoning goes like this. Given the amount of dithering that the US Fed has been indulging in, it is clear that Yellen and company will not hike rates until they have irrefutable proof that the US economy is in the pink of health. If the US economy, the largest in the world, is on the road to recovery for the first time since the housing crisis broke in 2007, hey, shouldn’t this be great news for investors?

After all, the whole problem for the global financial markets over the last seven years has been that global growth has been down in the dumps.

A nicely expanding US economy should be fundamentally good for India too. For one, accounting for $42 billion of India’s $310 billion in exports in 2014-15, America is by far the largest global marketplace for Indian goods and services. Three years ago, West Asia was the largest export market, but it has been easily overtaken by the US in the last couple of years. With petro-dollars evaporating and Chinese growth faltering, a stronger US economy can lift faltering Indian exports.

Two, over 60 per cent of India’s software exports go to the US markets. Given that the software sector is such a large employment generator as well as generous paymaster, improving fortunes for this sector cannot but improve prospects for Indian consumers. The many members of India Inc who have acquired global operations too should rejoice at a rejuvenated dollar.

Three, with the US economy looking up and its central bank withdrawing artificial props that have kept global assets afloat, stocks, bonds and commodities could finally shed their froth and align more with their underlying fundamentals. More realistic asset prices should help long-term investors who rely on stuff like earnings, growth and valuation multiples, to make better returns. They will no longer have to fret about wild-card liquidity flows.

Now that we know both sides of the argument, how will the event actually play out? Well, thanks to Yellen’s hawkish comments since mid-June 2015, we have already had the chance to witness a dress rehearsal. Financial markets, whether in India or abroad, seldom react to events after they are done and dusted. They factor them in as soon as new information is available.

Therefore, Indian market behaviour since mid-June, in the home stretch to this Fed meeting, should offer cues on what we can expect when the rate hike does materialise. In the last three months, Indian bond markets have been far more resilient to rate hike jitters than equities. FPI pullouts from debt market in the last three months have been minimal at $0.37 billion. Bond yields have, hence, barely changed.

FPIs have beaten a retreat from Indian equities, pulling out $2.52 billion on a net basis and this has triggered a 2500-plus point correction in the Sensex from its highs, a 10 per cent fall. The rupee has depreciated by about 3.5 per cent against the dollar too. But Indian stock and currency markets have fared far better than emerging market peers, thanks to the country’s relatively better fundamentals.

Overall, what this experience suggests is India may not be all that badly hit, if the Fed effects a rate hike three or six months down the line. That’s why it’s time that Indian investors, policymakers and the RBI stopped watching the Fed and carried on with business as usual.

That could really be the Fed’s game-plan too. If you allow financial market participants to stew over an uncertain event for an extended time, they will factor it in. Or at least get bored, and move on to next big thing.