US Fed rate hike impact on India

What is Interest Rate?

Essentially, interest is nothing more than the cost someone pays for the use of someone else's money. Homeowners know this scenario quite intimately. They have to use a bank's money, through a mortgage, to purchase a home, and they have to pay the bank for the privilege. Credit card users also know this scenario quite well - they borrow money for the short-term in order to buy something right away. But when it comes to the stock market and the impact of interest rates, the term usually refers to something other than the above examples - although we will see that they are affected as well.

The interest rate that applies to investors is the Federal Reserve's funds rate. This is the cost that banks are charged for borrowing money from Federal Reserve banks. Why is this number so important? It is the way the Federal Reserve (the "Fed") attempts to control inflation. Inflation is caused by too much money chasing too few goods (or too much demand for too little supply), which causes prices to increase. By influencing the amount of money available for purchasing goods, the Fed can control inflation. Other countries' central banks do the same thing for the same reason.

Basically, by increasing the federal funds rate, the Fed attempts to lower the supply of money by making it more expensive to obtain.

Stock Price Effects

Clearly, changes in the federal funds rate affect the behaviour of consumers and businesses, but the stock market is also affected. Remember that one method of valuing a company is to take the sum of all the expected future cash flows from that company discounted back to the present. To arrive at a stock's price, take the sum of the future discounted cash flow and divide it by the number of shares available. This price fluctuates as a result of the different expectations that people have about the company at different times. Because of those differences, they are willing to buy or sell shares at different prices.

If a company is seen as cutting back on its growth spending or is making less profit - either through higher debt expenses or less revenue from consumers - then the estimated amount of future cash flows will drop. All else being equal, this will lower the price of the company's stock. If enough companies experience declines in their stock prices, the whole market, or the indexes (like the Dow Jones Industrial Average or the S&P 500) that many people equate with the market, will go down.

Investment Effects

For many investors, a declining market or stock price is not a desirable outcome. Investors wish to see their invested money increase in value. Such gains come from stock price appreciation, the payment of dividends - or both. With a lowered expectation in the growth 

and future cash flows of the company, investors will not get as much growth from stock price appreciation, making stock ownership less desirable.

Furthermore, investing in stocks can be viewed as too risky compared to other investments. When the Fed raises the federal funds rate, newly offered government securities, such Treasury bills and bonds, are often viewed as the safest investments and will usually experience a corresponding increase in interest rates. In other words, the "risk-free" rate of return goes up, making these investments more desirable. When people invest in stocks, they need to be compensated for taking on the additional risk involved in such an investment, or a premium above the risk-free rate. The desired return for investing in stocks is the sum of the risk-free rate and the risk premium. Of course, different people have different risk premiums, depending on their own tolerances for risk and the companies they are buying into. In general, however, as the risk-free rate goes up, the total return required for investing in stocks also increases. Therefore, if the required risk premium decreases while the potential return remains the same or becomes lower, investors might feel that stocks have become too risky, and will put their money elsewhere.

US Fed Rate hike impact on India

After 2008 crisis, US Fed slashed the interest rates to 0.25% to support the economy. Since then US Fed has kept interest rate constant to increase liquidity in the US market. The emerging markets were the major beneficial of low-interest rates since investors invested in emerging markets because US market was fragile. But now the US economy is improved and on 17 September, Fed will contemplate to raise interest rates. This may lead to capital outflow from emerging markets since investors will prefer to invest in US market both in debt (better yield) and equity (better economic growth). Considering the strong growth in India, it is unlikely that the long-term investment story of Indian will get impacted due to this hike. However, US Fed’s decision may have a temporary negative impact on Indian markets in the following ways:

Impact on Indian Rupee

Indian Rupee will depreciate if US fed will raise the interest rate. US interest rate hike will be an indication that US economy is in good shape. Thus foreign investors in Indian markets will withdraw their money and invest in US market. In addition, the depreciation of Indian Rupee will lead to higher current account deficit and higher inflation.

Impacts on Indian equity market

On the fear of the possible US Interest rate hike equity market has already corrected recently. The hike in US interest rate hike will depreciate the Indian Rupee against US dollar. The foreign investors who have invested in Indian market will fear that the depreciation in Indian Rupee will wipe out their profits. Thus, they will start book profits.

For example, let’s say an investor invested USD 1,00,000 a year ago in India when the exchange rate is Rs 61 per US Dollar; in Indian Rupee he invested Rs 61,00,000. In one year, he made 10% return and his portfolio rose to Rs 67,10,000. After US interest rate hike, let say Indian Rupee depreciated to Rs 69 per US Dollar; his portfolio in US Dollar will dip to USD 97,246.38 and he will incur a loss of USD 2,753.62. Thus, he will prefer to book profits.

However, the IT and pharma are the biggest beneficiary of the Rupee depreciation and retreating US economy.

Impact on Indian Debt Market

There is a huge difference in interest rate in India and US. The policy rate is India is 7.25% while in the US it is 0.25%. Theoretically, an investor can borrow money from the US at 0.25% and invest in India for 7.25%. Thus, he will earn 7% return after paying back the borrowed money. The subsequent interest rate hikes by US Fed will reduce this gap and foreign investors will show reluctance to invest in India since the risk-reward will become less favourable. This is in addition to lower returns due to depreciation of the rupee.

Conclusion

India is not isolated from the impact of US interest rates. There may be some temporary capital outflow from the Indian market if US Fed hikes the interest rate. In long-run, Indian economy is attractive with a growth of 7% and inflation under control, thus investors will not be able to stay away from investing in India.