Why US interest rate hikes are a problem for emerging markets

Markets have been a bit lacklustre and in a state of fear on account of two main reasons. The first is the passage of the Land Acquisition Bill by Indian Parliament and the second is what the Federal Reserve in the USA would do in terms of interest rates. Parliament’s Budget session is still on and chances are that the government will have to call for a joint session of both houses to see the bill through. However, it is the development in the US that will have an immediate impact on the markets.

Much to the relief of markets across the world, the US Fed late on Wednesday night said it would hold on for a little longer before considering raising rates, and would wait for both economic growth and inflation to stabilise. Experts suggest an interest rate might come only in June 2015. 

India is well prepared to deal with any rate hike by the US Federal Reserve IMF chief Christine Lagarde said on Monday. RBI Governor Raghuram Rajan, himself a former chief economist of IMF, had also said earlier that there would be some volatility in emerging markets once the Fed decided to raise interest rates, but India is well prepared deal with the market volatility.

The mere fact that IMF chief and the central bank governor had to mention US interest rates suggests they were trying to pacify the markets from an expected turmoil. So how big is the US interest rate impact that sends global market in a tizzy every time the Fed meets?

We walk you through the impact of a hike in interest rate in USA in the Indian markets.

What does a rising interest rate in USA symbolise?

The end of easy money. Since the start of the financial meltdown crisis triggered by the collapse of Lehman Brothers, the US Federal Reserve has resorted to various measures to pump in liquidity in the economy. Three rounds of so-called Quantitative Easing (QE) failed to bring in the required impact on the economy. Though the Fed has withdrawn the QEs, they kept the ‘easy money’ tap open by keeping interest rates near zero. Money was available for free to conduct businesses in the USA. But most of the money was channelized into equity markets and that too in riskier assets like equities. Unlike previous bull runs, the one after 2008 saw money moving into equity markets only. None of the other asset classes like commodities attracted this money. So if interest rates are increased, access to this money will be costly. Chances are that inflow of funds will reverse if interest rates are increased.

Will only equity markets bear the brunt?

Any rise in interest rate has a direct impact on the country‘s currency. Rise of interest rate in the USA will strengthen the dollar. A strong dollar attracts money from other markets causing a ripple effect. While mentioning that India is prepared from an interest rate hike in the USA, Lagarde warned that a strengthening dollar will have a significant impact on Indian financial system.

Which markets are expected to be the worst affected?

Since the time of withdrawal of QEs, to every time Fed sneezes, emerging markets catch a cold. Being at the long end of the investment stick, the first markets from where allocations are withdrawn or reduced are the emerging markets. The recent selloff in emerging markets is on account of withdrawal of money from emerging markets’ equity traded funds (ETF). India however, is one of the strongest markets and most preferred ones in the emerging market basket.

What does history tell us about US interest rate hikes?

There have been 16 cycles since World War II during which the Fed has boosted interest rates. The risks are higher when the Fed first raises rates. During the six months before or after the first rate hike, the S&P 500 experience a decline of 5% or more 13 times. In other words, markets were hit negatively more than 80% of the time. Any hike in interest rate, if it happens will signal the end of the bond bull market that dates all the way back to 1981.

How bad is it for Indian market?

FII investment in Indian equities for the current year stood at over Rs 93,000 crore. In the debt market investment stood at over Rs 150,000 crore. It is the ‘hot money’ or the money that is invested in Indian equity markets for short term purposes that are at the risk of leaving the country. But if dollar strengthens against rupee, chances are money from the debt market will also leave Indian shores. Reserve Bank of India is on the process of reducing interest rates but if USA is increasing rates, the arbitrage opportunity will diminish, that is the biggest exit door that will open up if interest rates rise. RBI will have to use its forex reserve wisely to prevent the volatility in the rupee.