Abheek Barua: The fearsome trinity

Evaluating the impact of a Fed rate hike, given the fragile state of the global economy

After much shilly-shallying over the last couple of months, the United States Federal Reserve now appears a little more certain of hiking the interest rate in December this year. Job creation in August and September was weak but non-farm job gains in October at 271,000 were spectacular to say the least. Micro-surveys of the job market suggest that it is actually fairly tight and things like the quit-rate and the pace of job openings have been rising. These portend rising wages, and the Fed could be betting on the fact that this will lead to an increase in inflation that still remains below the 2 per cent mark.

There appears to be broad agreement among economists on the prediction that the Fed will follow a measured pace. HDFC Bank's take, for instance, is that the Fed will hike rates by just three-quarters of a percentage point over 2016. The Fed is also likely to take care to emphasise this slowness of increase whenever Fed Chair Janet Yellen and other senior members of the Fed's interest rate committee try to guide the press and markets. That said, if there is indeed a rate hike in December, it will mark the first major turn in many years in the global interest rate regime, a regime that had become used to the advanced economies holding their rates at zero. Thus the hike would indeed be a proverbial "big deal".

The impact of a Fed rate hike has to be viewed against the backdrop of the current state of the global economy and the myriad risks and challenges it faces. The International Monetary Fund's Global Financial Stability Report released last month provides a useful framework for getting a handle on them.

The IMF refers to a triad of challenges confronting the global economy and financial markets. It might be prudent for us, sitting in India, to take note of the fact that one node of the triad (perhaps the most critical node) happens to be the growing vulnerabilities of the emerging world. The Fund's emphasis on the problems of these economies should hardly come as a surprise as there is growing evidence that these economies are in trouble. For instance, the much-reported restructuring of a well-known multinational bank with large exposures to emerging markets should highlight the woes that financial entities operating in this space are facing. Some emerging markets might still be growing much faster than their developed market counterparts but they are decelerating at a somewhat rapid pace. Emerging Asia is very much part of this slowdown

The problem of slow growth is compounded by the fact companies and banks in these economies are sitting on huge amounts of loans. Private sector (including household) credit as a percentage of GDP for a basket of emerging markets (including India) has roughly doubled between 2004 and 2014, from 60 per cent to 120 per cent. The weakest spot is perhaps China - despite the fact that many of us have argued that the headline numbers miss out on the rapid strides in the consumption and service sectors.

China's manufacturing sector, especially the heavy industries and utilities, have been on a borrowing binge. These segments are incidentally dominated by state-owned enterprises with legacy issues of poor efficiency and excessive mollycoddling by the government. Dipping profitability is eroding the ability to service debt and non-performing assets are rising. While China's troubles with debt might top the list, other economies have similar problems. The problem of non-performing assets, for one, should be familiar to those in India.

Looking ahead, the fear is that an interest rate lift-off in the US could lead to a sharp increase in the effective borrowing costs for these struggling companies and banks. The fact that the Fed might just hike by a small amount does not necessarily mean that borrowing rates for markets will also rise by the same amount. High liquidity and zero rates in advanced economies led to an artificial compression of the 'risk premiums' that borrowers paid to get funds over the last six or seven years. The Fed rate hike and the build-up to it might cause a decompression (some of it is already happening) in premiums that could be both disorderly and much larger than the rise in the US's policy rates. This is the second node of the IMF's triad.

My view is that too much emphasis is placed on an economy's external debt position in gauging the impact of these interest rate shocks. Debt markets are 'contestable' even with some degree of controls on the use and maturity of debt, and the very threat of cheaper borrowing costs abroad tends to keep domestic rates in check. It works the other way as well and the net result is that domestic and global interest rates move together. One just needs to plot a chart of US and Indian long bond yields to appreciate this.

The implication is that is that economies irrespective of their levels of external borrowings will be affected by a rise in international rates. This could take the form of temporary dislocations in liquidity, a more permanent flight of capital or a string of defaults. Tarring all emerging markets with the same brush isn't a good idea.

This said, we shouldn't sit smug in the knowledge that India will be an island of calm. Sentiment is clearly against emerging markets and we have to produce signs of both a durable cyclical recovery and structural reform to decouple from the adverse momentum.

The third and final node of the IMF's triad reminds us of the fiscal problems that linger in the advanced economies especially Europe. These could resurface periodically and disrupt the financial markets. 2016 might not get off on a happy note after all.
The writer is chief economist, HDFC Bank.
These views are his own