US central bank lift-off on Thursday positive

A delay might lead to uncertainty and further capital outflows; but some want easy money to flow

Speculation is rife again on whether Janet Yellen, head of the US central bank (Federal Reserve), will raise interest rates on Thursday. The time, however, the markets are well prepared for the lift-off.

Some US economists believe the US central bank is already behind the curve and should have raised rates early this year. A rate rise in September will also mean that the recovery in the US economy is sustainable. There is a segment of the market, however, that would like the era of easy money to continue to fuel the rise in financial markets.

So, can India survive the rate rise? Even as India's macroeconomic fundamentals are significantly better than what they were in 2013, the risk of capital flight continues to be a real one. Since May this year, there has been a steady outflow of capital from Indian equities and bonds for many reasons. Foreign investors have sold equities worth $5 billion and $1.5 billion of bonds since May. If the US central bank opts to increase rates this month, capital outflows would hit markets.

A sharp fall in global commodity prices is expected to help India finance its current account deficit, even if capital flows reverse. But, a global slowdown is also expected to hit India's trade balance. Bank of America Merrill Lynch has cut India's FY16 export projection to $295 billion from $319 billion on account of a slower-than-expected recovery in the global economy. At the same time, the brokerage has also cut import projection to $443 billion from $467 billion on account of a slower-than-expected pick-up in non-oil and non-gold imports.

The vulnerability is not restricted to capital outflows from debt and equity markets. Dhananjay Sinha of Emkay Global says India's external fragility remains, despite a favourable current account deficit. He says, "Big foreign institutional investors investments in the Indian debt market in FY15 has compressed the carry spread close to historical low levels, meaning that rupee depreciation can trigger market volatility through rates markets, especially if the US central bank lift-off happens. This will further hit the volatility of the capital account balance." The current account deficit in the quarter ended June widened to 1.2 per cent of GDP (gross domestic product) and for the full year economists expect it to average at 1.3 per cent of GDP.

Even if the risk of capital outflows is a reality in the face of a rate hike by the Federal Reserve, a delay will lead to more uncertainty and further outflows.