Misplaced confidence

Fed rate hike may be priced in, but dangers remain

The United States Federal Reserve, at its next policy meeting in the middle of December, is widely expected to raise interest rates by 25 basis points. The effect of this long-anticipated tightening of US money supply on the global financial system has naturally been the subject of considerable interest. The impact on emerging markets was sharp when the last time the Fed made a change to its policies by announcing in 2013 its plan to "taper" the bond-buying programme known as quantitative easing. The impact on India was particularly drastic, with a sizeable fund flow out of the domestic markets. However, once the effects of the taper were absorbed, relative stability returned to the financial system, and in fact money began to flow into India again. The Fed may have learned some lessons about messaging from that occasion, and this time around it is expected that markets have priced in an increase of 25 basis points.

However, there is still some uncertainty about the Fed's future course of action - that is, its time-frame for further tightening after December. The consensus appears to be that further rate increases will be slow and measured. Even the International Monetary Fund has cautioned against precipitate tightening. If the Fed, during its December meeting, highlights the problems of extended low rates - the improper allocation of capital, including in asset bubbles - instead of concerns about the sustainability of the US growth recovery, then global markets might react adversely. With or without this guidance, there is a strong likelihood that the US dollar will strengthen over time; the continued easing by the European Central Bank may intensify that movement. This mechanism does support the view that, even if the December hike has been priced into Indian equities, the longer-term effects of global monetary policy on the domestic markets are still not absolutely clear.

Overconfidence about fund flows and the position of the rupee would thus be a mistake even though the end of the commodity boom has caused India's macro-economic numbers to look much better than they did in 2013. Although India is a bright spot in terms of global growth, corporate earnings have been largely flat for two years, and so it is difficult to see a renewed interest in Indian equities unless there is a move by the government towards headline-grabbing reform, a significant boost to infrastructure spending to remove production bottlenecks or a heftier demand stimulus. Part of the process of pricing in the Fed hike was that around $80 billion, by some estimates, was pulled out of emerging markets overall. India too saw foreign institutional investors selling - though the effects of that sale on the equity markets were mitigated through buying by domestic investors, and on the rupee by strong foreign direct investment flows. Foreign investors have also kept up their purchases of debt, hitting the cap on FII purchases of government securities all through 2015. Corporate bonds have also been in demand by foreign investors. The cap continued to be hit in spite of the Reserve Bank of India's September decision to increase permissible limits for FIIs in debt, on the back of which perhaps $2.5 billion flowed into India. However, India's prolonged and sharp decline in exports must be taken into account. There is no structural change that has taken place domestically since the "taper tantrum" of 2013. To genuinely insulate India from global monetary policy changes, domestic reform needs to gather pace.