Should A Rate Cut By The Us Federal Reserve Impact The Indian Markets?

Little local relevance

M R MADHAVAN

Money & Currency Analyst, Bank of America

To address the impact of Fed fund rate changes in Indian rates, we examine the transmission channels between the two.

In theory, the forward rate of any currency pair should equal the difference in the interest rate between the two currencies. Violation of this condition provides arbitrage opportunities.

Thus, a rate cut by the Fed will lead to either lower rates in the other economy or a rise in the forward premium or a combination of the two. In some cases, yield-seeking investors will push up the currency.

 

Indeed, some Asian economies have responded to the Fed rate cut immediately: Hong Kong and Taiwan with 25 basis points cuts and Thailand with a 50 basis points cut.

However, the arbitrage condition does not hold in the case of dollar/rupee. The reason is that capital flows are controlled.

Banks can borrow dollars for deployment in local markets only up to 25 per cent of their Tier-I capital; there is a cap on debt FIIs; and even corporates (who can typically borrow at a spread of 100-200 basis points over Libor) need permission above a certain quantum.

This means that the scope for cross-border arbitrage activity is limited. That, in turn, limits the impact of global rates on the Indian markets.

To be sure, this is the result of a conscious choice by the policymakers. A well-known result of economic theory says that three conditions (called the impossible trinity)