With US interest rates heading upwards, how will India fare?

On Wednesday, the US Federal Reserve chose to keep the federal funds rate unchanged. But the forward guidance provided by the committee suggests that the Fed is on course to raise interest rates during the course of the year. The committee now projects the federal funds rate at 0.9 per cent by the end of 2016, perking up to 1.6 per cent by 2017.

With higher interest rates in the US all but a certainty, will it lead to an exodus of portfolio money from emerging markets, especially India? Will the rupee succumb under pressure as risk-averse investors pull back from emerging markets or will markets take future hikes in its stride? Consider for instance in June 2013, when talk about the US Federal Reserve rolling back its massive monetary stimulus first surfaced. Emerging market (EM) currencies plummeted. The rupee fell by over 10 per cent by August.

But fast forward to December 2015 when the Fed raised its benchmark interest rate by 25 basis points. The reaction, this time around, was subdued. The rupee depreciated by 3.4 per cent by January and another one per cent in February. How will markets react now when the US transitions to a tighter monetary regime? The analyst and investor community seems confident that India is well placed to weather the storm. "India is now better prepared to deal with an interest rate hike in the US," says Dipen Shah, senior vice-president and head, private client group research, Kotak Securities. "A rate hike is now largely discounted by the market," he adds.

Devendra Pant, chief economist and senior director, India Ratings & Research, concurs. "A repeat of the taper tantrum is unlikely. There could be outflows. But these will be temporary." The confidence stems from the fact that compared to previous years India has seen an improvement in its macroeconomic fundamentals. It has seen a sharp decline in its current account deficit (CAD), fiscal deficit and inflation levels. Its growth prospects have also improved.

At the end of 2015-16, India's current account deficit fell to 1.1 per cent of gross domestic product, from 1.8 per cent in the previous financial year. "At current levels, capital inflows are sufficient to finance CAD, notwithstanding the recent hardness in crude prices and the fall in remittances," says Pant. India has also emerged as the largest recipient of foreign direct investment, eclipsing China. This places it in a comfortable position to finance the deficit. At the end of December 2015, India's CAD was lower than other emerging economies such as South Africa ($35.8 billion) and Columbia ($60.6 billion), though it was higher than others like Turkey ($8.1 billion), Brazil ($8.1 billion) and Indonesia ($13.5 billion).

On the inflation front too, there is reason to be optimistic. The consumer price index (CPI) was 5.5 per cent in April, well below the nine-plus per cent level that existed during the 2013. By comparison, CPI in Brazil was 9.3 per cent, 6.6 per cent in Turkey and 6.2 per cent in South Africa.

On growth prospects too, India fares better than other EMs. According to Citi Research, "India's five-year average return on equity has been among the highest in key EMs and we continue to expect it to be one of the high returns on equity markets in the EM space going forward."

Thus, on macroeconomic indicators, India is in a comfortable position. As experts believe that the impact of the Fed rate hike will be country specific, depending on their underlying fundamentals, India is relatively secure.

But capital outflows, especially from the debt segment, are possible in the short term. As the interest rate differential between the two countries is likely to fall, it will reduce the risk adjusted return. Hikes by the US, make US bonds more attractive and investors looking for stable returns will be gravitate towards US bonds.

EM bonds and equities are considered a risky asset, and therefore, India, which is often clubbed along with other emerging economies, is vulnerable to outflows when the US raises the federal funds rate. "Outflows, if occur, are more likely to happen in the debt segment" says Madan Sabnavis, chief economist, CARE Ratings. But the situation is not that straightforward. Despite an interest rate hike in December 2015, the 10-year US treasury has actually fallen from 2.23 per cent in December 2015 to 1.64 per cent in June 2016.

Also, higher interest rates in the US do not necessarily coincide with capital outflows.

During the early part of the last decade - the last time Fed initiated a rate hike cycle - capital flows to emerging markets soared, the rupee appreciated and exports boomed.

If the rate hike happens around September, it will coincide with the foreign currency non-resident deposits that are coming up for redemptions. This could increase volatility in the money market and exert pressure on the rupee.

But experts contend that the impact on the rupee will depend on the level of foreign exchange reserves at the time.

"The impact on of the redemptions depends on how deep the Reserve Bank of India has to dip into its forex reserves to meet the dollar demand," says Sabnavis, adding, "While there is no indication the $20 billion will be redeemed in one tranche, assuming it does, and if the reserves are $365 billion, the impact should be muted."