US Federal Reserve Policy Rates and Indian Economy

Answer:

It is an increase in the value of one currency in relation to another currency. Currencies appreciate against each other for a variety of reasons, including government policy, interest rates, trade balances and business cycles. Currency appreciation discourages a country's export activity as its products and services become costlier to buy.

Answer:

• Foreign portfolio investment (FPI) is the passive holding of securities and other financial assets by foreign investors. It does not provide the investor direct ownership of financial assets and is relatively liquid depending on market volatility.
• Stocks, mutual funds, bonds, exchange-traded funds, American Depositary Receipts, and Global Depositary Receipts are all examples of FPIs.

Answer:

• An FDI is an investment produced by a firm or individual in one country into business interests in another. An investor can purchase a direct business interest in a foreign country through FDI.
• FDI can be made in a variety of ways. Creating a subsidiary in another nation, acquiring or merging with an existing foreign company, or forming a joint venture partnership with a foreign corporation are some examples.

• Tight monetary policy implies the Central Bank (or authority in charge of Monetary Policy) is seeking to reduce the demand for money and limit the pace of economic expansion. Central banks engage in tight monetary policy when an economy is accelerating too quickly or inflation is rising too fast and usually involves increasing interest rates.
• Tight monetary policy of US Federal Reserve means hiking the federal funds rate–the rate at which banks lend to each other–increases borrowing rates and slows lending. Rate increases make borrowing less attractive as interest payments increase. It affects all types of borrowing including personal loans, mortgages, and interest rates on credit cards. Faster Fed rate could rattle financial markets and tighten financial conditions globally especially in emerging market economies like India. For instance, an aggressive monetary tightening would raise US yields and strengthen the US dollar against EM currencies like rupee. As a result, US- based foreign portfolio investors/Foreign institutional investors investing in countries like India would pull money out from here and invest in "safe heaven" US assets (Treasury bonds) and thus leading significant capital flight from India.
• Hence statement 1 is correct.
• The sudden stops and reversal of capital flows will lead to depreciation pressures on emerging market currencies like rupee. When foreign investors invest in equities, bonds and other financial assets in EMEs, they measure financial returns in the US dollar and other foreign currencies. If the EM currency depreciates against the US dollar, it decreases the value of their investments in dollar terms and, therefore, they may engage in distress sales of funds. This capital flight may increase interest cost of firms with a large stock of foreign currency debt as rising US dollar would increase the debt-servicing costs (in local currencies) for firms.
• Hence statement 2 is correct.
• Devaluation of domestic currency increases the currency risk associated with ECBs (as mostly foreign currency denominated). For instance, if at the time of raising loan through ECBs, 1 dollar was equal to Rs 75 and in future with depreciation/devaluation of domestic currency, 1 dollar becomes Rs 80. In this case, companies/firms borrowing through ECBs would have to pay back more as they convert more rupee with their dollar equivalent and in turn increases their currency risk.
• Hence statement 3 is not correct.
• Therefore the correct answer is option (b).

• Hike in interest rate in the US by the United States Federal Reserve leads not only to an outflow of funds from equities into US treasury bonds, but also to an outflow of funds from emerging economies to the US. Thus, it impacts Indian Government Bond Yields in a negative manner.
• So Statement 1 is correct.
• The multifaceted roles played by the RBI in the payment system, monetary policy, financial stability policy, and policy coordination with the Treasury gives it the operational ability to influence government bonds’ nominal yields by setting and changing the short-term interest rate and using other tools of monetary policy as it deems appropriate.
• So Statement 2 is correct.
• Short-term interest rate and pace of inflation are the key drivers of interest rates on government bonds.
• So Statement 3 is correct.
• Therefore the correct answer is option (d).