The Fed’s announcement of a 25 basis points hike in its funds rate on Wednesday — pushing up the benchmark lending rate to 0.50-0.75 per cent — could not have taken anyone by surprise. The fact that our portfolio investors had factored it into their calculations perhaps explains the outflow of $7.3 billion in October and November — apart from the fact that the calendar year-end is also a time for profit booking and portfolio reallocations. The Sensex lost 84 points and the rupee 35 paise on Thursday, but this is likely to pass as a blip, as indeed it did exactly a year ago. A more serious concern, however, is whether the Fed sticks to its prognosis of effecting three rate hikes in 2017. The Fed chair Janet Yellen subtly expressed reservations over US president-elect Donald Trump’s planned tax-credit-driven infrastructure stimulus at a time when inflation is inching ahead and unemployment is at 4.6 per cent — below what some US economists consider as the ‘natural rate of unemployment’ compatible with a healthy economy. It is of course another matter that the falling unemployment rate does not reflect the state of affairs on the ground in the US, as it fails to take into account those voluntarily dropping out of the workforce. It will not be surprising if Trump chooses to confront the Fed over its position, given his generally blunt, if not confrontationist, approach. Even so, we may well be seeing the end of an era of zero-bound rates, and with it the rush of capital flows into emerging markets such as India in the pursuit of higher returns. The yields on US treasuries have breached 2013 levels of 2.6 per cent. The question is whether India is prepared to deal with the new normal.
India’s external account pressures stem from weak exports and rising imports in the face of a creeping increase in oil prices. Trump’s resolve to squeeze H1 B visas could lead to a cutback in IT services exports; the US accounts for over 62 per cent of India’s total IT exports. The rupee, however, looks stable in the medium term, going by the modest 4.6 per cent premium in the rupee-dollar forward trade. While the RBI has the forex reserves to quell bouts of currency volatility, allowing the rupee to depreciate in a situation of still-benign crude prices may help India’s labour-intensive exports. If the current account deficit does go up to about 2 per cent of GDP in a year, it may have to be supported more by a combination of FDI flows and exports than portfolio flows in debt. All the more reason, then, for the Modi administration to project India as an investment-friendly destination, with an easy set of procedures and taxes to deal with.
If India keeps its current account deficit in check, it will free the Monetary Policy Committee of the responsibility of trying to manage the currency through the interest rate — allowing it instead to respond to the domestic growth-inflation mix.