The financial markets seem to be convinced that the absence of the word "patient" in the US Fed's post-policy meeting communique does not necessarily mean that it is ready to hike rates in June. Thus, it is not surprising that non-dollar assets, including the rupee and the much bruised euro, rallied in response. So, what explains the markets' comfort despite the non-appearance of the much analysed "p" word?
For one thing, the Fed revised its growth estimates for both 2015 and 2016, suggesting the fact that the spectacular improvement in the American job market hasn't quite mapped into an improvement in aggregate demand. Low inflation (potentially deflation), the consequence of subdued fuel prices as well as the excess supply of other goods in the economy clearly bothers the American monetary authority. As the communique worded, the Fed is likely to move when "there is adequate evidence of a further improvement in the labour market and when it is reasonably confident that inflation will move back to its 2 per cent objective over the medium term".
Besides, the fact that it scaled down its interest rate projections (the mid-point of the median Fed funds rate range for the initiated) was also a candid admission that it is not quite convinced about the sagacity of hiking interest rates immediately or of following through with aggressive hikes. It also raised concerns about the erosion in export competitiveness that a strong dollar (that would get stronger if the US hikes rates in the midst of an ocean of yen and euro liquidity) over the last few months entailed. Some analysts claim that the US monetary authorities are not yet sanguine that they have prepared the local and global markets adequately for a turn in the rate cycle. Thus, a hike in rates could unleash the kind of mayhem that we saw in May 2013 during the infamous "taper tantrums".
The Fed might have rolled the can down the road but is likely at some point to reach a dead end. Like most others, we are playing for a September rate hike of a quarter of a percentage point followed by a rather sedate one percentage point over 2016. The funny thing is that although the majority of market watchers expect a rate hike in September and the Fed has done its best to "sensitise" markets, the build-up to the hike and the hike itself are likely to breed considerable turbulence in the markets.
Conventionally, the analysis of rate action or monetary moves such as quantitative easing focuses on the impact on portfolio flows to non-dollar asset classes and non-US markets. However, the fact that emerging market companies have taken on huge quantities of dollar debt also poses a risk. Here are some numbers. Banks and bond investors have extended close to $9 trillion of US dollar credit to non-bank borrowers outside the US between 2008 and 2014, according to the Bank for International Settlements. Of this, $5.7 trillion has gone to emerging markets, including $3.1 trillion of bank loans and $2.6 trillion of international debt securities.. The fact that much of this increase in debt accumulation has come at a time of deteriorating earnings makes the increase in emerging market corporate debt all the more unsettling. Some of this borrowing has not been for "core" activities of companies but instead used to invest in securities or parked in bank deposits to earn "treasury" incomes, which compounds the problem.
A US rate hike and a spike in the dollar could pose a variety of problems even if they last for a quarter. The debt service burden, for one, will become heavier in domestic currency terms. Rolling dollar debt over might be a challenge for those who were banking on this to fund projects. The US Fed might try its best to prevent the collateral damage of its action but some bloodshed is likely.
Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is Principal Economist, CII
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