Who’s afraid of the Fed?

When the Fed finally hiked rates on December 16, what followed was not a ‘taper tantrum’, but a rise in equity markets the world over. It was a display of relief at the end of over two years of uncertainty, and of a sense of confidence in the prospects of the world’s largest economy. However, this cautious optimism was not carried over to the commodities market, a suggestion that a harder dollar may not help revive China’s sagging exports. That there was scarcely a ripple in India, with the Sensex rising 309 points and the rupee actually up 31 paise, suggests that the event has been factored in. There was a steady net outflow of portfolio capital in recent months. But the bigger story is that India’s external account now is ‘fundamentally’ FDI-driven, implying that it can weather bouts of volatility better than two years ago. Cumulative FDI flows as of June 2015 amounted to $271 billion, against $189 billion in the case of FPI.

India is growing at 7.5 per cent or so. Its current account deficit is under control, despite a consecutive 12-month fall in exports since December 2014, pointing to the absence of trade-related pressures on the currency so far. Those who set store by the twin deficit hypothesis — that a higher fiscal deficit will show up in the trade balance — can rest assured that the fiscal deficit appears to be on course to achieve this year’s target of 3.9 per cent of GDP, despite the Pay Commission award. What’s most important is that investor sentiment is encouraging. Despite falling exports, industry seems to be showing signs of an upturn, with the factory index rising steadily in recent months (even if one discounts the impact of a low base). The confidence generated by a sustained focus on easing the business climate seems to have had an impact. We are far better placed to handle external shocks than we were in mid-2013, when a scenario of policy paralysis and sluggish growth had led portfolio investors to rush for the door. Today, the interest rate can be used more to address domestic economy concerns than the exchange rate. Even if the rupee heads southward as the dollar hardens in 2016 (it has lost 6 per cent against the greenback since January), widening the trade gap in a sluggish world economy, our policy priority should be to keep FDI-led inflows going to offset the gap. Hence, an accommodative monetary policy, accompanied by prudent public spending that also provides a demand stimulus, should be pursued, alongside efforts to improve the business ecosystem.

However, there are vulnerabilities that cannot be overlooked, chief among them being industry’s exposure to external commercial borrowings. At about $180 billion, 70 per cent of which is unhedged, these could pose further problems to debt-burdened India Inc. As the MS Sahoo report on ECBs observed, hedging must be more strictly enforced and onshore derivative currency markets deepened to reduce such costs. But in sum, the Fed’s roadmap for next year need not disturb or derail our reforms agenda.

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