Time to take a hike

For other economies, especially emerging economies like India, a rate hike is likely to exacerbate turbulence in their financial markets. The mere expectation of a hike has seen foreign institutional investors pulling out money from emerging economies. In India, according to Care Ratings, FIIs have withdrawn $ 1.64 billion in November alone, and outflows in December are $ 852 million so far. Outflows create a demand for the dollar vis-à-vis the domestic currency; as such, several emerging market currencies have declined sharply. The rupee breached the psychological threshold of 67 to the dollar on Tuesday. Several other currencies like the Russian Ruble, Mexican Peso, South African Rand and Turkish Lira have depreciated more.

Capital flight is likely to create a sharp liquidity crunch in these markets, destabilising the calculations of several companies and central bankers.

So, is the rate hike a good thing?

Since 2008, the availability of cheap money has meant that several emerging economies have picked up substantial dollar-denominated debt. According to Richard Kozul-Wright of the United Nations Conference on Trade and Development, “Corporate debt in the developing world is estimated to have reached more than $ 18 trillion, with as much as $ 2 trillion of it in foreign currencies.” An interest rate hike raises the uneasy prospect of defaults.
For India, one could take a contrarian position and argue that a rate hike, which in essence signals a turnaround in the global bellwether economy, is actually a good sign. N Bhanumurthy, professor at the National Institute of Public Finance and Policy, says, “I believe it would be good news for India because it would imply that the US economy is growing and as such, its demand for our products, especially service exports, will go up in the medium to long term. Of course, in the short term, there will be negative impacts, especially in the exchange rate market.”
India’s exports have now fallen for 12 straight months. But “short-term” impacts are by definition the ones that do not affect economic growth. For instance, the Index of Industrial Production is unlikely to be affected by the short term volatility in exchange rates. So, the short-term pain is likely to turn into long-term gain for India.