Markets not unnerved by rising US interest rates
The dramatic 4% increase in US GDP in Q2-2014, it is true, is somewhat overstated. For one, the unusually freak weather which caused the Q1 contraction added to the Q2 bump. Two, once you strip out the 1.7 percentage point GDP contribution by the increase in private inventories—a one-time event—and the seven-quarter high 0.3 percentage point contribution of government consumption, Q2 growth looks more sedate. That said, the economy is in better shape—personal savings rates are up to 5.3%, suggesting that consumption growth is strong—and that is why the US Fed is carrying on with its taper. Indeed, given the pick up in US inflation, the Fed’s statement has been a bit more hawkish; more important, the US GDP numbers resulted in 10-year US government bond yields rising 9 bps to 2.56% and the dollar strengthening against most currencies.
In such a situation, the traditional RBI response would be to raise interest rates. That, however, assumes it is interest rate arbitrage that is driving FII investments into Indian debt. One possibility is that FIIs are a lot more sanguine about the prospects of the currency, but as the dollar gains strength, it is not clear as to how market sentiment can change; the only thing that is certain is when this happens, as in the past, it can be quite sudden. Besides, with the debt-to-equity split roughly even—$12.1 billion of FII equity has come in 2014 so far as compared to $12.9 billion of debt—it is not clear if RBI’s focus should be on FII debt or equity. Since equity funds are coming in search of growth, an appropriate RBI strategy would be to cut rates. More so since, as our lead columnist today argues, while there is virtually no demand for credit, underlying inflationary pressures have reduced with a very sharp fiscal correction along with low procurement price hikes as well as announcements of dumping FCI stock to dampen prices. Under normal circumstances, a tough call for the central bank. What makes it easier this time around, however, is the fact that monetary tightening is not working; indeed, banks are so flush with liquidity, short-term deposit rates are also falling a bit. With the prospects of global export demand also looking less bright and the expected burst in government spending not taking place, there aren’t too many other policy levers to stimulate growth—clearing projects is a good thing, but even if all policy hurdles disappear, low capacity utilisation levels mean no one is going to be rushing in to complete projects.