No backwash effects

US Federal Reserve Chairman Alan Greenspan has said that the US economy is now on a much firmer footing and would not need the support of ultra-low interest rates any longer.

This is the closest he has come to saying that the long apprehended hike in interest rates would be made soon. Indicating the extent of the hike, he has said that the Federal Open Market Committee will move at a measured pace and make changes that are of a marginal order. It is now almost certain therefore that US rates will be hiked by a quarter of one percentage point.

Over the last three months it has become increasingly clear that the risk of deflation has disappeared, and given way to mild inflationary pressures that first surfaced through a rise in inflation numbers for March this year.

Since then the direction of interest rates had become obvious. However, the high productivity rates and low inflation in the US have allowed the Fed to keep interest rates at rock bottom levels till date. Now it is a matter of days before this begins to change.

For the Indian markets, this has not been very good news. But it is also not something to fret about. A marginal hike in US interest rates has already been discounted by most major market players, and should not provoke any large outflow of money from the emerging markets.

Indeed, foreign portfolio investors will probably continue to get higher returns than are feasible in their home markets. Also, in keeping with the risk-reward trade-off, most of the flows are seeking quality earnings and not just absolute earnings.

With strong economic fundamentals, a conservative monetary policy and plenty of good companies with high standards of corporate governance, and with the political situation having settled down, India remains an attractive destination.

As for domestic monetary policy and interest rates, the Fed's view will change little, if anything at all. Indian inflation levels are benign at around 5 per cent, the foreign exchange reserves are at all time highs and liquidity in the domestic banking system is comfortable.

Since Indian interest rates did not fall as much as they might have, there is no need for an upward thrust now to interest rates to match whatever the Fed does in the near term. Nor are there any local pressure points that could prompt the central bank into hiking rates. The rupee is largely stable, and the central bank is in a position to put sand in the wheels if there are any sharp movements either way.

Also, while the US economy may be peaking in its productivity cycle, the Indian recovery is still nascent and there is a great deal riding on low interest rates.

With the benefit of low rates, domestic banks are about midway in cleaning up their balance sheets, with the result that the Indian banking system is much stronger today than it was three years ago.