THE WORLD WILL NOT END IF US HIKES RATES!

By Ruma Dubey

Today evening, at 7.30 PM, US Fed Chairman, Janet Yellen is scheduled to give a speech at Jackson Hole, Wyoming and the topic is ‘Designing Resilient Monetary Policy Frameworks for the Future. It is NOT a Federal Reserve meet but the big hullaballoo is about “some indirect reference” to the timing of a rate hike. This reading-between-the-lines is typical of US press – they want to know what is not said and then create an expectation around the meeting. And this has been happening from times immemorial and the markets, strangely never really learning from history, continues to get manipulated by this “build-up”.

The Indian markets are down today, lackluster because we also do not know which way to go. The perception is also that maybe if rate hikes come in USA, Foreign Institutional Investors (FIIs) as well as Foreign Direct Investments (FDI) will beat a hasty retreat from India.

FIIs have been selling consistently from 22nd August; they have been net sellers. Yesterday also they were net sellers to the tune of Rs.372 crore but overall for the month of August, they remain net buyers. So does this mean that FIIs will pack their bags and bid adieu and scoot from India? Unlikely. FIIs simply cannot afford to move out lock, stock and barrel out of India as the opportunity that the country presents it too good to ignore. What we are witnessing now and will see in the coming days, will be a very logical reaction but it does not mean that they are getting out. 

Apart from this, even practically it makes no sense. The differential between the interest rates in USA and in India is big. A small 0.25% rate hike will not be attractive enough. India on the other hand is on a rate reduction cycle; they have been no rate cuts recently but we are not talking about a rate hike here, only a cut. Thus a cut in India and a hike in US will bring down the risk-adjusted return. What could happen is that some FII money could get diverted to bonds as a rate hike signals that USA is a safe haven and investment in bonds will give them stable and safer returns.

Coming back to India, money which comes via Foreign Direct Investment (FDI) is the real measure, more than FIIs pumping “hot money” into the stock market. FDI inflow increase indicates that they still find attractive enough to make some long term and much bigger commitments. According to the Department of Industrial Policy and Promotion (DIPP) data, FDI inflows grew 7% to $10.55 billion during the first quarter against $9.88 billion in January-March 2015. The sectors, which attracted maximum FDI during the period, include computer hardware and software, services, telecommunications, power, pharmaceuticals and trading business. In terms of countries, India received maximum overseas inflows from the US, Singapore, Mauritius, Japan and the Netherlands.

Thus if and when the Federal Reserve announces a rate hike, is there a real fear of our Indian markets crashing? Logically, a crash into a bottomless pit will not happen. Two factors support this belief. Firstly, when stimulus was withdrawn in 2010, the world economies were fragile, still hurting and nursing the wounds inflicted by the collapse of Wall Street. This time around, economies are showing signs of resurgence though Brexit effect looms large but more importantly, the US economy is also slowly but surely getting back its vigor. Also one has to remember, it is not the Fed alone which drives stock prices – it is corporate performances too and individual companies have started showing better profits and margins, thanks to various cost cutting measures and improving production efficiencies. This means hard times have made companies leaner, fiscally more prudent and efficient.

One can brush off this logic as too Utopian but then the second factor more or less will drive home the truth. When FIIs get the money, they put it in emerging markets to take advantage of the arbitrages. When the money goes to that country, say, India, it will come in the form of dollars which will be with RBI. Now it is foolish to let so much money sit idle, so RBI utilizes this money itself to buy US Treasuries. So money comes from USA and goes back there.

As per the US Treasury records, in June’16, India held $117 billion worth of US Treasury Securities, which is at same levels as that in June 2015. China remains the number one holder – till end of June’16, it held US$1241 billion worth of US Treasury securities. Japan comes in second place, holding US$1141 billion.  (Take a look at the major foreign holders of US Treasury securities - http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt)

So when the FIIs start exiting, the RBI would need to give them back their money and to raise money, naturally, it will have to sell its US Treasury holdings.  Can you imagine what will happen to US if India, China and other economies, all start selling the Treasury securities, even if at a loss? The US economy could collapse. Now that is something which the Fed will not allow to happen. And that brings us to the conclusion – the hiking of interest rate will not lead to stock markets crash; this the Fed will ensure, for the safety of its own economy, to ease this rate hike cycle in a slow and gradual way.

So let’s not give so much weightage to this Jackson Hole meet or for that matter a 0.25% rate hike – its purely psychological.