Why are Indian markets reacting to potential US interest rate hike?

The likely hike in the US interest rates is one of the reasons, apart from slowing Chinese economy and the global market meltdown, which has had the Indian markets on an erratic path.

US had indicated a potential rate hike last year, but has been shelving plans of normalizing its policy regime based on weaker-than-expected growth indicators from the world's biggest economy.

While Fed takes stock of its economy and policy stance, Indian markets have been consistently reacting in the run up to policy meetings and depending on its outcome. Going ahead too, the BSE and NSE will eye the US interest rates.

Why is everyone talking about the US Fed interest rate?

This is the first time in nearly a decade that US will hike its interest rates. The Federal Reserve has kept rates at near zero levels for almost a decade. The last time US had cut rates was during the 2008 global financial crash.

Inflation is now at a level that the Fed is comfortable with, and unemployment rates have been declining, prompting the Fed to move closer to a firmer interest rate policy. The Fed will also be cutting down on its bond buying programme, reigning in liquidity in the system. However, the Fed is still elusive about the timing of the rate cut, due to weaker-than-expected economic indicators out of the US, with the recent global equity market meltdown and worldwide growth worries only adding to the soup.

But why are Indian markets reacting?

US is one of the leading trade partner for India, especially in software sector. Which means, a major overhaul in economic policies will have an impact on the Indian market.

Firm-er dollar

A hike in US interest rate hikes will lend strength to an already strong dollar as investors will flock to the greenback as safe haven. In the past year alone, the US dollar has firmed against other currencies. The dollar is up nearly 14% against its basket of emerging market currencies.

On the flipside, emerging market currencies are at multi-year lows due to the contagion effect of China's yuan devaluation. China devalued its currency thrice to make its exports more lucrative in the global market, in a bid to give a push to its slowing economy.

The rupee, as a result, in the last one month alone has weakened nearly 3.91% against the dollar. The Indian unit had tail spun to nearly 67 before retreating back toward 66-level. Further firmness in the dollar if the US Fed hikes interest rates, will make the already vulnerable rupee even weaker.

A weak rupee will make dollar-denominated commodities like metals and oil more expensive to buy. Industrial metals, led by copper, is trading at six-year lows in the international market, however, a weak rupee will offset the gains in rupee terms. Oil prices too have been at nearly six-and-a-half year low. But India will not be able to take full advantage of such low oil prices due to the weakness in the rupee. Imported food items will also become dearer, adding to inflation in the country.

FII outflow

An interest rate hike in the US will also lead to foreign investors pulling out of the Indian market, preferring to keep their capital in dollar terms, or look for more lucrative markets to invest in.

Foreign Institutional Investors have already been pulling out of emerging market economies, including India, in the wake of worries about a global slowdown. During such period, foreign investors pull out of developing economies which may be more vulnerable to an impact of external factors.

FIIs sold Rs 5,142 crore worth of shares in one day on August 28. For the month, as much as Rs 9,140 crore has been withdrawn by FIIs. This has been the highest outflow since June 2013, when Rs 9,300 crore was withdrawn from Indian equities, according to this moneylife article. FPIs withdrew a net amount of Rs 16,936 crore from the equities till August 28, while they pulled out Rs 619 crore from the debt markets during the same period, translating into a net outflow of Rs 17,555 crore (2.65 billion), according to data available with the depositories. This is against a net inflow of Rs 5,323 crore into Indian markets in July. 

A rate hike may increase the momentum of FII outflows from Indian markets, adding further cause for the markets to react.

Corporate debt

Indian companies have huge overseas borrowings. With an appreciation in the dollar, the value of this external debt will increase.

According to a Finance Ministry report, India's external debt increased by 6.6% at nearly Rs 31.4 lakh crore, up from Rs 29.4 lakh crore. The share of government's debt in this only accounts for 18.9%, the rest is corporate debt, which will see a significant surge in the value of the borrowings.