The impact of US Fed’s hawkish monetary policy on Indian economy.

The 2008 global financial crisis.

The US Federal Reserve which is a parallel of India’s RBI, has been treading an accommodative monetary policy since the onset of 2008 global financial crisis when the sub-prime lending practices coupled with poorly structured instruments of finance like mortgage based assets (MBS) raised the risk of credit financing and subdued the economic activity.

US being the largest economy of the World always has a profound impact on rest of the World economies in terms of exchange rate and trade relations, and this is why it is necessary to understand the underpinnings of the crisis that emanated in 2008 in US financial markets and jostled the capital markets world over before we go on to debate the concept of quantitative easing, fiscal cliff and the latest hawkish monetary policy stance indicated by the US Fed.

In years prior to 2008, US financial markets had been growing at a phenomenal pace with securitization of newly invented instruments of structured finance like Asset based securities (ABS) and mortgage based securities (MBS). Let us understand the concept of MBS in order to comprehend the reasons of the 2008 sub-prime mortgage crisis.

In US, the housing market is huge in terms of quantum of houses constructed, houses leased, houses sold and the money involved. Houses can be bought on a 30 year loan period at a 3-4 % rate of interest. People considered investment in real estate as a safe bet, often taking a loan to buy houses, hoping the prices of real-estate to rise quickly enabling them to pay off their housing loan as well as earn some capital gain.

The banks and investment houses would provide such housing loans at easy terms in the hope that the real-estate market would not saturate in the coming time and borrowers would keep repaying their equated monthly installments (emi). The banks and investment houses further securitized the housing loan agreement that they’d enter with the loanee and use it as a collateral to raise further loan with another investment bank in US or abroad.

When the real-estate market/housing market reached at a point of saturation, i.e. when supply of houses exceeded demand, the prices of real-estate stopped appreciating and in-fact declined. The borrowers who were under the impression of making a capital gain to pay off their housing loan started to default. The bankers and investment houses who had financed the buying of the houses experienced a rise in the default rate. Furthermore, the structured finance instruments that had been securitized with the loan agreements as the underlying assets depreciated in value and in-fact became zero in value. This chain of events occurred on such a massive scale in US, Ireland and other European countries that short term lending rates spiked to abnormally high levels.

The impact of sub-prime lending on India

In January 2008, the severity of the sub-prime lending crisis in US were known publically. The cost of credit rose and stock markets plummeted to rock bottom levels. In India, the call money rate which usually fluctuated in the range of 5.5 – 6 %, rose to 52 % on 21st Jan 2008. BSE’s Sensitivity index (SENSEX) fell to sub 8000 levels from 17000 levels, as foreign investors sold off their equity holdings to protect their capital from currency exchange risks and also factored in lower profit projections for the companies on account of drying up of trade financing and lower foreign trade projections. The outflow of this Hot Money did lead to a crash in stock markets world over, but the long lasting ramifications were felt in terms of subdued foreign trade as India’s major export destinations in the west were experiencing turbulence in their financial markets on account of ripple effect of the sub-prime crisis that had emanated in the US. India’s volume of foreign trade fell but due to resiliency of its domestic economy on account of higher aggregate demand by the rural economy, Indian economy escaped unscathed and posted a decent economic growth rate. Moreover, the macro-economic indicators measured in terms of Fiscal deficit, inflation, Current account deficit etc. were in comfortable territory and thus India easily weathered the 2008 global financial crisis.

Accomodative monetary policy of US Fed post 2008 global financial crisis.

Post 2008 Global Financial crisis, economic activity in US fell to a low level. Business houses were left with un-utilized production capacity which couldn’t be utilized due to deficiency in aggregate demand. The un-utilized machinery eventually became obsolete and required capital expenditure for replacement. But due to deficiency in aggregate demand and subdued global trade scenario, the firms were unwilling to undertake this investment. Unemployment rose and per capital income fell.

In order to boost economic activity, generate jobs and spur trade and investment activity, US Fed adopted an accommodative monetary policy stance, and thus gradually lowered interest rates to near zero levels. Even the US government has been undertaking public investment to boost economic growth and this expenditure widened the debt levels of US Govt. It is this accommodative policy stance and public expenditure undertaken by the US as per it’s reflationary policy that raised debt levels to such a huge extent that US economy is said to have reached it’s limit in terms of its ability to pump-prime its economy which the term ‘fiscal cliff’ attempts to explain.

Gradually as economy revived and came out of recessionary phase as indicated by growing non-farm payroll data released by US Labour Department, US Fed headed by Janet Yallen indicated it’s intentions to end the Quantitative easing process thereby reversing the accommodative monetary policy and cutting down on fiscal expenditure undertaken by the US Govt.

Rising interest rates in US and impact on India.
As US Fed embarks on a hawkish monetary policy, the interest differential between US and India is bound to narrow, making investments in US economy more lucarative in terms of return on investment and capital gain. As economic activity revives in US, profit margins of US based companies would rise and thus with their ability to pay higher dividends and capital gain prospects, foreign institutional investors (FII) would love to park their money in US financial markets.

As foreign capital will flow out of Indian stock markets, demand for Indian Rupee (INR) would fall and Rupee would thus depreciate in terms of USD. The volatility in exchange rate would deter business houses from investing in India and India being a capital scarce country would experience stagnancy in the very short term.

However, in the long term as Real Effective Exchange Rate (REER) depreciates, Indian exports would become competitive in global markets and India’s trade deficit would narrow down, i.e. if other world nations don’t resort to sterilization.

Moreover, the revival of economic growth in the western nations who are also India’s major trading partners would raise the prospects of India’s foreign trade and enable India to earn valuable foreign exchange, provided the exchange rate reflects the new international world order realistically.
It is therefore hard to ascertain the complete impact of US Fed’s hawkish monetary policy on India, but according to RBI governor, India is well placed to absorb the shocks of the new adjustments that will result from the World’s biggest economy raising interest rates after a sabbatical of 7 years.

By: Abhinav