The interest rate hike of 50 basis points by the US Federal Reserve (Fed) is a step taken to curb inflation in an overheated US economy. This move is characteristic of tactics being taken in tandem with the anti-inflation policies undertaken by most governments across the world. Consumers prefer consumption rather than saving which provides low returns. Increased spending leads to inflation and also increases the imports into the country causing a trade deficit. Also the habit of borrowing to consume has made the US the most overleveraged economy at a consumer level.

The rate hike by the Fed has implications not only for the US but also other countries whose economies are closely linked to the US markets and India with its close Nasdaq linkages is no exception. Lets see Why..?

The United States has been the undisputed leader in terms of economic growth and the bastion of global capitalism with economic relations across the globe. US consumers have been very active in investing in US mutual funds which have generated fabulous returns by investing in the emerging stock markets including India. Low interest rates had made current consumption attractive over saving in banks and consequently there was a rush towards investment in mutual funds which in turn fueled a major bull run in the US bourses.

India has been considered as one of the "promising emerging economies" in the world and the investors abroad have taken the advantage of helping themselves to "rentier income". Rentier income is the income from investments made in stocks and mutual funds in both domestic and overseas markets. What is the implication of the interest rate hike on the Indian Economy and the stock markets?

As far as the Indian markets are concerned they have been largely been driven by the Nasdaq boom. The rise in the interest rates in the US are likely to make US bonds more attractive vis-a-vis equities and lead to a consequent shift of funds out of equities and into bonds. Also the old economy stocks which were just about seeing a recovery are likely to see an increase in their financial risk as a result. This will have two implications for Indian markets. Firstly, a fall in the US markets is going to have a spillover effect on the Indian equities. Secondly, this long awaited correction in the Indian markets is going to make US tech stocks relatively cheaper leading to a fresh outflow of funds from the Indian markets.

Now for the other dimension. The Indian Rupee, having crossed the psychological barrier of Rs.44, stands at its lowest value with respect to the dollar and the forex reserves have gone down considerably in April. The interest rate hike would cost India more on imports and a "pull out" of FII investments from the Indian markets. The subsequent rise in inflation in India will cause the relative real interest rates to decline thereby forcing an interest rate hike here in the process dampening the nascent corporate recovery.

Dollar loans would be costlier as the LIBOR (international reference rate) would also go up. The Reganomic tactic is right for the US however it would cost India and the other Asian markets dearly. The Indian economy would no doubt gear up to take on the challenge by means of the economic reforms of the government, however the nature of the recovery would seem to be rather reactive than proactive. Rightly it has been said that when it rains in the US we open our umbrellas in India.

Deepak V Kuriakose