With a growing economy and declining unemployment rate, the US economy is returning to normalcy which has prompted the US Federal Reserve Bank (the central bank) to raise interest rates. In March 2018, the Fed raised benchmark interest rates to between 1.50% and 1.75%.
However, the interest rate hike in the world's largest economy has implications for emerging economies like India. Emerging countries with weaker economies will be severely hit because a Fed rate hike will trigger capital outflows from these economies. This is because money will flow towards US markets as the interest rate gap between the emerging economies and the US market falls. US treasuries will become more attractive and safer investment avenues. Moreover, the trade deficit of emerging economies will widen as weak rupee will make imports costlier. A weaker rupee on the back of a rate hike, will also inflate India’s oil import bill since over 80% of the country’s oil requirement is imported.
A rate hike in the US will lead to a stronger dollar and a weaker rupee, which will lower investment returns for foreign investors and prompt them to sell. Except long-term foreign portfolio investors (FPIs), other foreign investors prefer short-term trade without hedging. A volatile currency will impact their returns on investment. Also, firms that have borrowed heavily in dollars in the overseas market may see higher cost on borrowings.
The interest rate hikes and a stronger dollar will lead to a rise in yields on US treasuries. In other words, the US bonds will offer a better rate of return than before. There is an inverse relationship between bond prices and interest rates, meaning as interest rates rise, bond prices fall, and vice versa. The longer the maturity of the bond, the more it will fluctuate in relation to interest rates. The rise in yields also narrows the rate differential between the US and India, making Indian bonds less attractive for foreign portfolio investors and which may witness a sell-off thereby causing capital outflows.