A temporary reprieve

United States Federal Reserve gives emerging markets a breather

The United States Federal Reserve adopted a policy of calculated inaction at its meeting that concluded on Wednesday. Global financial markets responded favourably, pulling back from the edge of what could have been a crisis. From a United States-centric perspective, it no longer made sense to guarantee low dollar policy rates "for a considerable period" according to earlier Fed policy statements. Indeed the Fed has indicated that it will raise dollar rates in 2015. But it will be "patient", which its governor clarified means that the Fed will not look to raise rates for at least two more policy meetings. In effect, that gives the world economy a grace period of six months. Immediate rate increases would have put global markets under great pressure. If the United States treasury yields had risen at this moment, there would have been a big bull run in favour of the dollar. A super-strong dollar would have ripple effects on global investment flows, and on trade balances. By maintaining status quo and signalling a time frame, the Fed has allowed other central banks and investors to review their plans for the first half of 2015. China has recently cut policy rates. The Bank of Japan (which also has a policy meeting this week) is expected to continue its quantitative expansion programme, given deflationary conditions.

What will the Reserve Bank of India (RBI) do? Domestic inflation is trending down and well below the RBI's target. But growth is also down, with the Index of Industrial Production showing contraction in October. There is no sign of the investment cycle picking up with banks possessing excess liquidity. But the rupee has also weakened versus the dollar. The current account deficit is only two per cent of gross domestic product or GDP - but it is widening due to a poor trade balance. Meeting the budgeted fiscal deficit target of 4.1 per cent of GDP is posing a big challenge. Without a strong dose of expenditure cuts, the deficit target may be missed by a considerable margin. Are rate cuts advisable in the face of the rising twin deficits and what would be a sweet spot for the rupee?

The Fed's policy statement will surely affect overall emerging market allocations. The RBI's actions, and the Budget at end-February, will affect India's share of allocations for all emerging markets. A United States rate increase would have caused a flight to safety with emerging markets allocations being cut. A pullback out of the emerging markets is not unlikely anyway, given that growth is tepid in China, Brazil and South Africa. India could be the exception to the emerging markets slowdown in that GDP growth is expected to improve, and so India may get a higher share of emerging markets allocations through 2015. Indian markets saw corrections as money was pulled out in anticipation of a more hawkish Fed policy. That money has come back, temporarily at least. But making a case for an exception for India through 2015 will depend to a large extent on the Budget and the reformist credibility of the present government.