Recap:
In this piece, we will explore how interest rate cycles influence capital flows between the United States(US) and Emerging Market Economies(EMEs) and how institutions in EMEs, especially in India, manage those risks.
US Interest Rates and Their Impact on EMEs:
US Interest Rate Cycles have a significant amount of say in determining the economic variants of the EMEs. They influence Capital Flows, Currency Values, and Economic Stability. When the US Fed raises the interest rates, it leads to an outflow of capital from EMEs. Investors try to increase the propensity of returns by seeking safe havens in the US Bond market. This crucial phenomenon is termed “Interest Rate Differential“. Interest Rate Differential refers to a situation, in which when US rates increase, the probability of a risk-adjusted return in the US increases, hence, investors move away their portfolios from the EMEs. Thus, it is the difference in interest rates between the US and the EME.
- Currency Depreciation and Inflation:
When the interest rate increases in the US market, and as a result the capital outflow increases, there is a significant impact on the EME currency that tends to depreciate in such a situation. Currency depreciation exacerbates inflation. For example, India relies heavily on imported crude, and any devaluation in the Rupee, due to such economic shock increases the fiscal strain. The depreciating Rupee also impacts debt servicing costs, increasing macroeconomic vulnerabilities.
- Equity Markets:
Equity markets are particularly prone to the rate fluctuations in the US. To cite an instance from an Indian market context, when the Fed increases rates, the Foreign Institutional Investors(FIIs) with large positions holdings in Indian listed stocks and bonds pull out their investments. This capital outflow creates large corrections in the Indian markets. This is accompanied by significant volatility as well.
Equity markets have seen a pull-off of close to 1.36 lakh crores from the Indian markets from September 2024 to November 2024. October 2024, alone witnessed an outflow of close to 94,000 crores which is the largest monthly withdrawal ever recorded. This was followed by a 26,000 crores sell-off in November 2024. The sell-off can be attributed to the overall economic environment. Usually, the sell-off creates a domino effect of further weakening of the Indian rupee against the dollar, which further contributes to inflation.
- Impact on Sovereign Debt:
As the US interest rate rises, India’s sovereign debt becomes more expensive. Higher yields on US Treasury bonds increase the borrowing costs. India’s sovereign debt as of the second quarter of 2024 stood at USD 682.3 billion reflecting a USD ~59 billion increase from the previous year. Per, the Reserve Bank of India(RBI), the US dollar-denominated debt is ~54% of the external debt. This severely impacts the debt servicing costs when the US Fed increases the interest rates.
Risk Management Strategies Employed During Such Scenarios by India:
The major strategies employed by EMEs are:
Monetary Policy Decisions:
The RBI plays a significant role in mitigating the impact of US interest rate fluctuations. To mitigate the inflationary risks, the RBI enters into a rate-increasing course. RBI entered into a rate-increasing spree from May 2022, reaching 6.5% till February 2023. Throughout 2024, RBI maintained the repo rates at 6.5% during its monetary policy meetings. However, this approach comes with its own set of concerns – degrowth, reduced consumer demand, and dampening domestic investment.
Currency Hedging:
To reduce the impact of currency devaluation, India has often employed hedging instruments such as forward contracts and currency swaps. Some recent examples are, the RBI signed a currency swap agreement with Maldives Monetary Authority(MMA) under the SAARC currency swap framework for 2024-27. This agreement allows the Maldives to access USD 400 million through the USD/Euro swap window and Rs 3000 crores through the Indian Rupee Swap Window. The INR swap acts as a risk mitigation mechanism by promoting the usage of the rupee in regional transactions and providing a financial safety net for short-term foreign exchange liquidity issues.
Building Foreign Exchange Reserves:
India has also focused on accumulating foreign exchange reserves(forex) to safeguard its economy during large-scale capital outflows. The forex reserves have surpassed USD 600 billion, which has provided a buffer against capital outflows. This enables RBI to intervene in currency markets, stabilizing the rupee during heightened global uncertainty.
Focus on Foreign Direct Investment:
India has in recent years, focused aggressively on Foreign Direct Investment(FDI) instead of relying on Foreign Portfolio Investors(FPIs). FDI is considered more stable and less correlated to short-term interest rate fluctuations. Some of the noteworthy initiatives are the Make in India Campaign, Easing the Regulatory Environment, and Diversification of FDI sources. Due to these policies, India has witnessed an increase in Foreign Investments in the Technology, Renewable, and Infrastructure sectors.
The cyclical nature of US interest rates has a significant impact on global capital flows, particularly in EMEs like India. India has portrayed a high degree of resilience through a multimodal approach. India has been able to manage a high degree of uncertainty spanning – currency devaluations to market fluctuations. However as the next wave of business cycles emerges, India must equip itself with proactive strategies to ensure growth and tackle inflation. India’s adaptive strategies underscore its growing role as a role model for other EMEs amid such global capital flow challenges.
