US Federal Rate Hike and its Implications on the USD-INR Exchange Rate

Posted in Finance Articles, Total Reads: 1213 , Published on 18 March 2015
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Recently, an issue of the Economic Times (original source: Bloomberg), carried an article (source [1]) predicting the probabilities of the Fed hiking interest rate by 50, 75 and 100 basis points in certain months in 2015 (a basis point is equal to 0.01 %).


The data is captured in the table below:

Interest Rate (%)

0.50 %

0.75 %

1.00 %

Apr-15

0.327

0.120

0.019

Jun-15

0.347

0.183

0.050

jul-15

0.326

0.287

0.135

sep-15

0.282

0.303

0.186

oct-15

0.196

0.289

0.252

dec-15

0.144

0.251

0.268



The numbers in the table above represent the probability of the Fed raising the interest by the number of basis points indicated by the column headings in the month indicated by the row headings. It can be seen that the market seems to think that April 2015 is the point where the Fed will make its first move. I will try to provide an analysis of how this can affect the USR/INR exchange rate.


The exchange rate between any two currencies is connected by a relation called the uncovered interest rate parity. It basically implies that there should be no arbitrage opportunity for FX spot traders (see [1] for an in-depth explanation). Currently, since the interest rate in India is much higher than that in the US (India – 8.46%, US – 0.11%), the INR should appreciate relative to the USD. However, since investors are aware of Fed’s intentions, they will act accordingly. As per recent news reports, FII inflows into India have already started slowing down (see [3] for details). This has made the INR volatile (see figure below – taken from source [4]) and the government has used up about USD 3 bn of its USD 320 bn forex reserves over the past two weeks to stabilise the INR (note the stability later in the graph). Basically, the govt. buys INR using USD to create artificial demand for the INR to make it appreciate. This effect cancels the depreciating effect caused by reversals of FII movements.


As a country with a current account deficit that has caused major trouble for the exchange rates in the past, the movements have to be noted. An increasing CAD basically means more demand for imports implying more demand for USD, and thus a depreciating INR. However, recently, due to the oil supply glut and the consequent fall in oil prices, India’s CAD has improved to USD 10.7 bn down from USD 12.2 bn last month. Since the Indian govt. subsidises a major part of the cost of oil, this in turn also means lesser expense on oil subsidy for the Indian govt. thus improving the fiscal deficit. A high fiscal deficit is not a desirable situation since it increases the possibility of the govt. using its authority to print money to cover up the situation causing the local currency to drastically depreciate. Moreover, there is every chance of a rating downgrade which will make external borrowing more expensive.


With regards to inflation, increasing inflation will cause the purchasing power of the local currency (INR) to go down. This makes investing in the local currency undesirable and thus will cause the local currency to depreciate against the USD. Purchasing power is usually measured by calculating real income, which is nominal (or actual) income divided by the price index. Since income is usually sticky in the short run, an increase in the Consumer Price Index/Wholesale Price Index will cause a fall in real income. A consumer price index (CPI) measures changes in the price level of a market basket of consumer goods and services purchased by households (source [5]). The Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods (source [6]). The CPI and WPI inflation rates for Aug 2014 are 7.8 % and 3.74 % (sources [7] and [8]). RBI Governor Raghuram Rajan has been able to restrain inflation rates in India and he is still unwilling to lower the interest rate. One possible reason could be the role this plays in keeping the USD/INR stable.


Above all, Narendra Modi’s landslide victory in the elections along with his pro-development image in both India and abroad has helped FII inflows into India. The volatility scenario in India is much better than what it was during UPA-2 tenure. Fed raising the interest rates might actually not cause a rampant exodus from the Indian markets. Moreover, given that the RBI has over USD 300 bn in foreign exchange reserves, the USD/INR can be expected to remain stable over the next year or so.


In the next 5 years, given Narendra Modi’s “Make in India” pitch, India could possibly be headed to where China has been all these years. This would mean an increase in exports leading to huge foreign exchange reserves. When Indian goods are bought by other nations, payment is in USD. When Indian exporters convert these USD to INR, the INR will appreciate. Thus, I think that there is every chance that the INR might appreciate in the long-term.


This article has been authored by Sandipan Dutta from IIM Calcutta


Sources

1. http://articles.economictimes.indiatimes.com/2014-09-19/news/54108997_1_april-2015-hike-rate

2. http://en.wikipedia.org/wiki/Interest_rate_parity#Uncovered_interest_rate_parity

3. http://articles.economictimes.indiatimes.com/2014-09-16/news/53983434_1_lakh-crore-net-investment-rs-40

4. http://www.xe.com/currencycharts/?from=USD&to=INR&view=1W

5. http://en.wikipedia.org/wiki/Consumer_price_index

6. http://en.wikipedia.org/wiki/Wholesale_price_index

7. http://www.tradingeconomics.com/india/consumer-price-index-cpi

8. http://www.eaindustry.nic.in/cmonthly.pdf



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