The impact of Fed rate hike

Indian financial markets turned turbulent last week as fears of a global slowdown affected prices. The nervousness is also, to a large part, due to the impending monetary policy normalisation by the US Federal Reserve (Fed) that includes hikes in the federal fund rate.

As September 2015, the month when the Fed intends to begin the rate hike cycle, approaches, investors are quailing in their boots. Each tiny scrap of data and even the most insignificant of speeches are being analysed threadbare to gauge the Fed’s intentions.

These fears are not unfounded as there is likely to be intense volatility in global markets as the Fed begins reversing some of the extraordinary measures it took to combat the crisis in 2007 and 2008. Many believe that the ‘taper tantrum’ — when asset prices crashed in 2013 on worries that the Fed will decrease its monthly infusion of money into the economy — was a mere teaser when compared to what can happen once the Fed starts this process.

As the era of cheap money draws to a close, asset prices across the globe are likely to be impacted. There is likely to be selling in many riskier assets as investors pull money out to repay the dollar loans and to repatriate money to safer havens. These outflows will, in turn, make currencies depreciate, impacting global trade and finally the economic growth.

But given that the Fed has been preparing the ground for many months now, incessantly talking about the forthcoming normalisation, it is possible that the going might not get too bad. If the rate hikes are very slow and in step with the growth in the US and other countries, it is possible that the adjustment process is easier and we get away with a minor short-term turbulence.

Here’s a look at the likely fallout of the Fed’s move on asset classes in general and those in India, in particular. But before that, let us skim over the events that led to this impasse.

It all began with the sub-prime crisis in 2007 and 2008 — when the credit market froze, large banks collapsed, economic growth stalled and asset prices plummeted across the globe. The trigger was the downward reversal in property prices in the US. The delinquencies that followed, particularly in sub-prime mortgages, resulted in heavy losses to many financial institutions. The situation was complicated by banks and other institutions selling exotic derivative products constructed around these sub-prime mortgages. These instruments turned worthless following the defaults; shrinking the balance sheets of lending institutions, bringing global lending to a virtual halt.

The Federal Reserve as well as other central banks across the world, including India, were quick in their response to this crisis. The Fed brought down the federal fund rate from 5.25 per cent in August 2007 to a target rate between 0 and 0.25 per cent by December 2008.

Besides cutting interest rate, the Federal Reserve also used other means to resuscitate the credit market, including providing short-term liquidity to banks and other financial institutions and approving bilateral currency swap agreements with other countries.

The Federal Reserve also purchased longer term securities from the market, thus directly infusing liquidity into the system. These purchases of mortgage-backed securities and longer term treasury securities, also termed quantitative easing or QE, were aimed at providing funds to the banks which could then be used for lending, thus propping up asset prices and warding off inflation.

Well, it is obvious that these easy monetary conditions cannot exist indefinitely. The FOMC had laid down certain conditions before these measures were reversed such as the long-term unemployment rate declining below 5.2 per cent and inflation staying at 2 per cent. With the unemployment rate moving close to 5.4 in June, the Fed now appears reasonably comfortable to begin raising rates. CPI urban inflation at 0.1 per cent is far below its target, but this metric has dropped from 2.1 per cent in June 2014, mainly due to decline in crude and other commodity prices. Inflation is, therefore, not a prime concern for the Fed.

What will policy normalisation mean? It will result in a) increase in the federal fund rate and other short-term interest rates to normal levels and b) reduction in the Federal Reserve’s holding of securities purchased in the course of the quantitative easing to a more reasonable level.

Besides hiking interest rates, the Fed also has the onerous task of trimming its balance sheet that has bloated following the QE program. The assets of Federal Reserve were $865 billion in August 2007. This expanded to $4.4 trillion by the end of July 2015. While there is no roadmap on selling the long-term securities purchased from banks and other institutions yet, once the Fed begins selling them, US treasury yields are going to shoot higher, causing another round of exodus from emerging market bonds.

The greater worry at present is, however, the impending increase in the federal fund rate. The near-zero rate of interest in the US since the end of 2008 has resulted in companies borrowing in dollars at close to zero to buy financial assets across the globe or to lend to borrowers in other countries.

This ‘dollar carry trade’ is already under duress as the dollar has appreciated almost 30 per cent since 2009-low. This means that borrowers will have to pay more of the local currencies to repay the dollar loan. Two, as interest rates start moving higher, the spreads will reduce, resulting in a rush to pay back these loans. This will involve selling assets purchased with the money.

According to a research paper put out by the Bank for International Settlements, many borrowers outside the US have been taking dollar loans to lend to non-bank borrowers outside the US. Such loans have increased from $6 trillion to $9 trillion since the financial crisis. This number is large compared to offshore euro credit ($2.5 trillion) and yen credit ($0.6 trillion). This growth in dollar carry trade that has resulted in asset price inflation across the world is the key trouble spot.

As dollar appreciates further following a rate hike, there will be a rush to sell other assets to pay back the dollar loans.

The Indian equity market has been receiving a slew of funds from foreign investors since the beginning of 2009 (when the dollar carry trade began and the first round of stimulus began).

Net foreign investment in Indian equity market in this period was around $102 billion.

But there are many reasons why the risk of all this money flowing out is lower. From the beginning of 2009 till now, the Sensex is up more than 200 per cent but the gain in dollar terms is just 116 per cent. Again, many of the listed stocks have delivered poor returns since 2008.

An analysis of the change in market capitalisation of various countries between 2008 and now in dollar terms shows that Indian market cap is down 11 per cent since January 2008. This is despite the Sensex trading 37 per cent above this level currently. The difference is largely explained by the currency movement.

According to this metric, US market capitalisation has gained the most, up 38 per cent from January 2008. It is, therefore, likely that many global investors preferred US equity markets due to the better economic prospects and the sexy tech and social media stocks where possibility of heady gains were brighter. This renders US equity more vulnerable to a decline if de-leveraging begins.

Since equity investors take a bet on the growth prospects of the economy, India’s relatively superior growth can help ward off a steep sell-off. The high impact cost in Indian markets is another deterrent to sustained selling in equities.

Equity prices could, however, be adversely impacted if the rupee goes into a tailspin against the dollar. The resulting increase in the cost of foreign borrowing and imported inputs will deal a blow to India Inc’s earnings.

While Indian equity appears less vulnerable, the same cannot be said of debt.

Foreign investors have ploughed in close to $53 billion in debt since the beginning of 2009. While $13 billion was pulled out in 2013 when the Fed announced its intention to start tapering its quantitative easing, we have received $32 billion since the beginning of 2014.

There is a greater threat of destabilisation of the economy due to the foreign participation in debt since these investors are more short-term in their investment horizon and are very sensitive to yields and currency movements.

There has been a lot of interest in emerging market bonds since the crisis due to the interest rate arbitrage offered by the higher interest rates in emerging markets. The International Monetary Fund’s Financial Stability Report states that assets of emerging market bond funds have more than doubled since 2009, and currently stand at close to $1 trillion. It is possible that a chunk of these investments was funded by the dollar carry trade.

Two, the bond market in India is relatively less liquid. The IMF’s Financial Stability Report also points out that money tends to flee from illiquid assets such as EM bonds when risk-aversion rises. Indian bonds, therefore, face greater risk when compared to equity.

The positives for Indian bonds are the high real yield and improving macros. These will make the foreign investors return, albeit after a hiatus.

Gold bulls are rare these days and it is unlikely that global investors would have taken the trouble to use the dollar carry trade to buy gold. Investors have largely moved out of gold since September 2011 and this is reflected in the holding of SPDR, the US’s largest gold ETF, the holdings of which have declined from 1,350 tonnes in December 2012 to 671 tonnes currently. Spike in dollar, once the rates start moving higher, can however push gold prices further down.

Other commodities, including crude, have also underperformed for some time now, reducing the likelihood of a sell-off in these assets. The TR CRB index is down 46 per cent from January 2008, reflecting the dire strait of commodity prices.

Real estate regulations within India do not allow foreign investors to invest directly in realty, thus insulating this segment from the Fed monetary tightening. Foreign investors have invested in real estate, start-ups and unlisted companies through private equity and venture capital funds but these are long-term investors who are unlikely to churn their assets or face redemption pressure following a US interest rate hike.

Indian companies have been increasingly resorting to foreign borrowings to meet their financing needs. Of India’s total external debt, the government accounts for less than one-fifth of the share, implying that Indian companies are exposed to greater risk from Fed interest rate hike. The proportion of non-government debt in the country’s external debt has increased from 73.7 per cent towards the end of December 2007 to 80.5 per cent now.

Indian companies have been increasingly skirting the high cost of borrowing in India by borrowing overseas at half the interest, thanks to the near-zero rates of interest in many countries.

According to the Reserve Bank of India, external commercial borrowings towards end-March 2015 stood at $182 billion. This is up from $57 billion towards end-December 2007.

The proportion of debt denominated in dollars has risen from 54 per cent in December 2007 to 59 per cent by December 2014.

All this spells bad news for Indian companies as they will have higher outgo when they repay their loans or pay the interest, if dollar appreciates further. The higher cost of borrowings on future dollar loans will also impact operating margins.

If the European Central Bank and the Bank of Japan too begin raising rates in tandem, it will further exacerbate the growing cost of funding.