India catches cold with US interest rate rise

Pritam Singh & Vanessa Petrelli Correa

Pritam Singh
Professor of Economics, Oxford Brookes University, UK

Vanessa Petrelli Correa
Professor, University of Uberlandia, Brazil

THE US Federal Reserve has again raised interest rate to 2.25 per cent with another increase expected in December, three more in 2019 and one in 2020. Based on experience, it is expected that this interest rate rise too will have adverse consequences for emerging economies.

India and Brazil are two of the most important emerging economies in the global economy and both have recently experienced rapid falls in the exchange rate of their currencies. Behind these currency falls (Indian Rupee and Brazilian Real), there are some tendencies in the US-dominated global capitalist economy which affect currency fluctuations in all emerging economies. But there are also some distinctive internal/domestic factors in India and Brazil that need to be taken into account to have a better grasp of the fall in the exchange rates of the rupee and Brazilian real.

Regarding the impact of movements in the global capitalist economy on exchange rate volatility, there are three important stages in the last decade of the global capitalist economic crisis since the fall of Lehman Brothers in September 15, 2008 which have important bearings on the shifts in currency exchange rates.

Kickoff by 2008 crises 

The first stage of this currency volatility started with the 2008 crisis that had led to a massive fall in business confidence in developed capitalist economies especially in the US, the nerve centre of the crisis. One manifestation was financial institutions holding on to their reserves and reluctant to invest. This is what created the credit crunch. The onset of the credit crunch by making borrowing more difficult, led to fall in profitability and investment. This contributed further to reinforcing the crisis. Alarmed by the prospect of deepening crisis due to credit crunch, the governments in the US and Europe lowered the interest rates to encourage borrowing and kick start economic activities. This fall in the interest rates in the two geo-economies and the relatively higher interest rates in the emerging economies led to a massive speculative movement of financial flows to the emerging economies. The increased demand for the currencies of the emerging economies led to rise in the exchange rates of currencies of nearly all emerging economies but especially of India and Brazil.

The relative fall in the exchange rate of dollar facilitating increase in US exports and the easing of credit availability at low interest rate led to revival of some business activity in USA. Very soon this revival showing declining unemployment and possible rise in wages started generating fears about the possible emergence of inflation in the US economy.

Sensitive speculative flows 

The second stage in this currency volatility emerged in 2013 when hints started being thrown by the Federal Reserve Bank that there might be a need to raise the interest rate to control inflationary pressures in US economy. Even without the interest rate being raised, but merely the possibility of being raised had important implications because the global financial flows, especially speculative flows, are very sensitive to not only the actual but even the expected movements in US interest rate. The reverse direction of financial flows towards the US started emerging leading to some appreciation, though not dramatic, in the exchange rate of dollar vis a vis the currencies of emerging economies.

Fed finally hikes rates

The third crucial stage in this current exchange rate volatility started with the first interest rate rise by Federal Reserve in December 2015 followed by a marginal increase in 2016, three increases in 2017 and has culminated in already three rises in 2018. These have led to massive speculative flows of financial capital to the US resulting in dramatic rise in exchange rate of dollar and a massive fall in the currencies of emerging economies which seems so uncontrollable that even when some central banks (Argentina, Indonesia and Turkey) tried to raise their domestic interest rates to stem the outward flow of capital, it did not work.

Within this external financial environment, some of the domestic political and economic factors in Brazil and India are worth noting to capture the decline in the exchange rate of Real and Rupee respectively.

Domestic contributors 

In Brazil, elections in October to Brazilian presidency and parliament have set the scene for intervention of speculative capital. A corporate-controlled media is generating an economic fear that a left-wing president might come to power which might lead to economic policies aimed at curbing the free market powers of big financial capital. This fear is further accelerating the speculative flow of capital to the US and decline in the exchange rate of Brazil’s currency. The political calculation behind this media strategy is that the average middle-class voter sensitive to exchange rate volatility is more likely to vote for market friendly right-wing candidates and even a marginal shift of this nature might eventually tilt the balance in favour of a right-wing candidate in the final count.

In India, the global financial capital, once favourable to the Modi regime, is becoming wary of its economic governance in the light of disastrous economic policies such as demonetisation, GST and NPA fiasco of big banks. This economic misgovernance coupled with the confrontational foreign policy gestures towards Pakistan and violence-generating internal political mismanagement is creating an overall future scenario suggesting instability and uncertainty. This expected future political and economic instability is a domestic contributor to capital outflows and the relative rise of dollar against the rupee.

The fact that Brazil is even more sensitive than India to speculative flows is due to relatively higher level of integration of Brazilian economy with the global capitalist economy. One big lesson from this experience of exchange rate fluctuations for future economic policy in India is to create and strengthen institutional checks against further opening of the economy to speculative flows of capital that contribute to increased volatility.