Thursday, March 24, 2011

US Fed Rate Cut: Will it Queer the pitch for some of the World’s fastest growing countries like India.

The federal fund rate is reduced to 0.25% in Jan 2009 following the subprime crises from the high of 5.25%in Sept 2007. Federal Fund rate is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed. Federal Discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility.

The Subprime event in 2009 has forced the Federal Open Market Committee to reduce interest US Fed interest rate to 0.25%. The rate is maintained at the same level currently. The Cut in interest rate is an indication the banks are more likely to borrow which puts more reserves into the banking system. More money supply means banks can charge lower interest rates. There is a direct relationship with the discount rate and the overall level of interest rates. In other words, the direction of the changes is the same. For instance, if the Fed lowers the discount rate, interest rates in general will fall.

With the current cut of Fed Interest rate, additional investment opportunities are discouraged in United States. American Investors will look for alternative investment opportunity in developing countries like India and China. This will led to Foreign Institutional Investors inflows in developing countries. There is a positive impact on stock and forex market of developing countries due to increase in liquidity by foreign institutional investors. With preferential liquidity in the countries capital market, the market may reach new high, but the valuations may not be specific. In view of higher dollar return, American investors will infuse dollar in the economy of developing countries, thereby strengthen local currency and weakens dollar. Strong local currency will adversely affect the exporter as the Indians goods will become costly to foreigners. This will discourage the foreigners to purchase and use Indian goods and commodity, thereby affecting the export sales for Indian Companies. Export is critical to the growth of Indian Economy. Major Industry to be affected includes IT Sector, Hotel Industry and other manufacturer whose revenue accounts for major share from United States. The reduction is turnover of the company will be followed by fall in employment rate and lower per capita income.

The bonds prices are inversely related to interest rate. With cut in federal interest rate, the bonds prices will increase pushing the yield down. The developing country’s Central bank is expected to announce a series of measure like open market operations, discount rate etc to ensure that excess liquidity in the economy does not add to inflation. The Central bank will sell financial asset like government bonds, foreign currency, or gold to curb the excess money in circulation.

Later on heavy foreign exchange outflows in the wake of sustained selling by FIIs on the bourses and withdrawal of funds will put additional pressure on dollar demand.

Strong local currency will benefit importer as the imports will be cheaper. Major Industry to benefit include Oil companies, electronic goods etc. Also, strong local currency gives the Indian companies better bargaining power at time of foreign acquisition. However, in cases where huge foreign investment is in form of setting up plant in the country, then the developing country will be benefited with fall in unemployment rate and rise in per capita income. Strong local currency will also be beneficial for companies whose major revenue share is in domestic currency. Such companies can borrow cheaper foreign debt and expand their capex to capture additional market share.

The Cut in Fed rate will affect companies in different sector in different ways.