Will Fed Interest Rate Hikes Derail the Indian Economy?

The US Federal Reserve has signaled its intent to raise interest rates on Wednesday, and it is widely expected that this will be the first in a series of rate hikes. This tightening sequence, along with the expected trade protectionist measures from the Trump Administration, will create considerable headwinds for the Indian economy in 2017.

The last time that the Fed tried to tighten monetary policy was in 2013, and that set off a panic sale in asset markets that has become known as the “taper tantrum“. The effect of the taper tantrum on the Indian economy can be seen in the chart below that shows US bond yields and Indian GDP growth. The sharp upturn in US bond yields due to the 2013 taper tantrum led to a decline in Indian GDP growth from 7% to 6%.

A Fed tightening will lead to a stronger dollar and this will act as a monetary tightening for the Indian economy. A sustained Fed hike may also lead to an actual rate hike by the RBI in order to defend the Rupee. This weakening of the Rupee is associated with lower economic growth. The following chart shows a scatterplot of Indian GDP growth against the previous quarter’s USDINR exchange rate changes. There is a clear downward slope, showing that a rise in the USDINR rate, i.e. a weakening of the Rupee, leads to lower GDP growth.

A linear regression of GDP growth against the previous quarter’s change in exchange rate shows a highly significant relationship. The regression suggests that each percentage point weakening of the INR cuts GDP growth by 15 basis points. This would mean that if the Rupee were to decline to around 70 then GDP growth would fall by about 1%.

OLS, using observations 1997:3-2016:4 (T = 78)
Dependent variable: GDPGR

            coefficient  std. error   t-ratio    p-value 
const           7.34122    0.309395    23.73     7.06e-037 ***
INRGR_1       −0.145344   0.0330137   −4.403     3.45e-05 ***

The Indian and the world economy will be flying into considerable headwinds in 2017. The Trump Administration has signaled its intent to pursue trade protectionism and to attempt to reverse the US trade balance. This will have the effect of reversing the flow of US Dollars into the global economy and therefore, have a pronounced tightening effect. In addition, the Fed will also embark on a series of interest rate hikes. The net result will be a huge dollar appreciation that will prove ruinous for emerging markets, especially those like India that run a current account deficit.

In this scenario, the RBI and the government will need to act on several fronts in order to contain the damage. The RBI will have to defend the Rupee strongly, and the government will have to do all it can to protect Indian exporters from unfair trade restrictions. But above all, the government will need to set aside its populist election promises, and finally embark on economic reforms that have long been promised and never actually delivered.

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