US Fed rate hike: Janet Yellen just made Modi’s task of repairing a ‘demonetised’ economy lot tougher

More than the quarter percentage point Fed rate hike, emerging markets, particularly India, should worry more about Janet Yellen’s warning that there will be a faster pace of rate hikes in 2017. Currency dealers forecast at least three such rate hikes in 2017 as US economy gains steam.

This’ll immediately put tremendous caution on the central banks of emerging economies, particularly India, when they plan to tinker with interest rates for fear of a capital flight. In India, foreign institutional investors have already begun to pull out funds back to the US post demonetisation drive by Prime Minister Narendra Modi that has weakened the economy for at least in the short-term.

 US Fed rate hike: Janet Yellen just made Modi’s task of repairing a ‘demonetised’ economy lot tougher

Representational image. Reuters

Janet Yellen’s rate hike will mean a few things for India: One, in the backdrop of a strengthening US economy and dollar (which is what the rate hike suggests) there will be more pressure on the Indian rupee. The chances that the rupee testing new lows here cannot be ruled out. The unit touched a record low of 68.86 against the US dollar last month breaking its past record in August 2013. Remember, in that one month alone, i.e between 24 October and 23 November, FIIs have pulled out Rs 17,172 crore from the Indian market, against an inflow of Rs 4,414 crore a month before, according to Sebi data. If the rupee devaluates further it will have negative implications on fiscal deficit since the oil import bill goes up, and also creates sentimental impact on other segments of financial markets, mainly bond and equity. Bond yields are already on the rise.

Second, if indeed the Federal Reserve goes for more rate hikes ahead, the Narendra Modi-government’s task of repairing the economy from the demonetisation shock will get tougher, thereby weakening the domestic economic fundamentals further. In hindsight, the timing of demonetisation is proving to be very bad for Indian economy and its policy makers, as external scenario is turning turbulent. Already, there is a significant cost to the economy on account of demonetisation implementation. Besides, there is a yet-to-be estimated hit on the economy, and the cost of transition such as printing the new notes and the transfer of these bills to across the country.

The service sector, manufacturing and consumer demand have been hit bad. The RBI, which announced a status quo in rates in last policy, doesn’t have full picture yet on the impact of note ban on the economy. In a scenario, where more US Fed rate hikes are expected and inflation is nose diving to the floor of the central bank’s band, the RBI may have to rethink on future rate cut plans and might even consider reversing its policy stance sooner than it thought.

A weakening rupee will be partially good news to exporters since their dollar receivables will yield more but importers will take a hit. But, the poor demand conditions will act as a drag. The real double-whammy is for the economy, which is already struggling due to the demonetisation cash crunch even as companies are battling poor demand and inventory pile up.

The PM will have to push hard emergency measures to resolve the cash crunch at the earliest and regain the balance of the economy. If necessary, the government should seek outsourcing the note printing from abroad as local mints are running in full capacity. Solving the cash-crunch fast is key since, already, the key indicators of economy have begun to show major weakness.

The fall in PMI data, auto sales, fast dropping inflation (both wholesale and retail) and various projections showing a sharp fall in economic growth are the indications. The actual impact of demonetisation on farm sector and loss of employment is yet to be ascertained but most economists expect a notable adverse impact across due to the prolonging cash crunch, which, going by the most optimistic estimates, can get solved only by mid-next year.

As pointed out earlier, PM Modi’s task of repairing the economy is now set to get even tougher given the uncertainty of future rate actions from the US Fed.

Updated Date: Dec 15, 2016 10:41:55 IST