Wednesday, January 7, 2015

The rise in US interest rates and associated change in the direction of capital flows, the fall in oil prices and its impact on Emerging economies



The US Federal reserve has adopted a tight monetary policy stance by raising interest rates. But the increasing of liquidity by European and Chinese central banks has provided a balancing act. This may not be enough to offset the overall withdrawal of liquidity especially when one considers the reduction in funds available with the oil producing countries due to the falling oil prices.
It is hard to determine how these policies would affect India and other developing countries especially when one takes into account the lack of transparency in the financial systems of these countries.
Higher interest rates in US will result in withdrawal of funds from these countries to be invested in the US Federal Reserve Bonds. To offset this depletion of Foreign Exchange reserves, these developing countries will have to make policy provisions them more export friendly. This will involve currency devaluation and lowering of export duties which will result in high inflation and reduced revenue to the governments.
With the reduced revenue, the governments of these emerging economies will have to finance their deficit by raising the tax rates. The central banks may also have to raise the interest rates at some point which will result in low spending and slowing down of overall economic growth.
For India in Particular, due to the positive market sentiments, the effect might not be as pronounced as other developing countries. Though the pull out of foreign investments may result in a stronger dollar in near term, but the renewed emphasis towards exports and softening of oil prices will lead to stabilization of Indian Rupee.

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