Capital Outflow from India Unlikely to Halt Despite Interest Rate Hike
Despite India raising interest rates for the first time in four years, the record trend of capital outflow from the country is unlikely to stop. This has placed the Reserve Bank of India (RBI) in a difficult position, as it must simultaneously manage a weakening rupee and rising inflation.
In line with the growing expectations of economists and investors, the RBI raised its policy interest rate by 25 basis points. However, analysts believe this modest hike may not be sufficient to alleviate pressure on the Indian rupee or attract foreign investment back into Indian markets.
Rising hedging costs (the process of mitigating currency exchange rate risks) are making Indian assets less attractive to foreign investors—particularly as global interest rates, oil prices, and US dollar movements impact emerging markets.
India's Rate Hike May Not Be Enough
While the 25-basis-point hike was anticipated, investors had hoped for a stronger signal from the central bank regarding its readiness to raise rates further if necessary.
"It’s a good start. But is it enough? Probably not," said Carl Vermassen, Portfolio Manager for Emerging Market Fixed Income at the Zurich-based firm Vontobel.
He added that the RBI could have used stronger language in its policy statement to address the pressure on the rupee.
According to traders and analysts, a clearer commitment to defending the currency and raising rates again if needed could have strengthened the rupee's position. Instead, the central bank employed cautious language regarding a gradual shift toward a tighter policy stance.
Rupee Under Pressure
The Indian rupee has been one of the worst-performing Asian currencies this year, having depreciated by approximately 7 percent against the US dollar. Following the RBI's decision on interest rates, the rupee depreciated rapidly, nearing an all-time low of 96.96 against the dollar.
Another area of concern is the significant rise in currency hedging costs. In the week following the rate hike, hedging costs increased by more than 60 basis points, making Indian investments less attractive to foreign investors.
The combined impact of currency depreciation and rising hedging costs could reduce returns on Indian stocks and bonds for international investors. The trend of foreign investors withdrawing capital from India continues.
A record $30 billion in foreign capital has flowed out of the Indian stock market this year. Additionally, foreign debt inflows have turned negative since the beginning of September.
Sat Dhura, a portfolio manager at Janus Henderson Investors, noted that the rate hike might slightly slow the pace of capital outflows, as it strengthens confidence in the central bank.
However, he opined that the interest rate hike is not sufficient to reverse the overall trend.
According to Dhura, international investors are likely to focus more on US Treasury bond yields, the strength of the dollar, oil prices, corporate earnings, and market valuations.
He stated that the 25-basis-point rate hike was not enough to foster a positive outlook regarding the Indian stock market for his firm.
Narrowing interest rate differential between India and the US
Another challenge for India is the narrowing gap between Indian and US interest rates.
The yield premium (excess return) on India's 10-year government bonds compared to equivalent US and German securities has fallen to its lowest level in years.
The spread between the yield on India's 10-year bonds and the US benchmark rate is now at a record low.
This narrow interest rate spread could make Indian bonds less attractive to foreign investors, as they are receiving comparatively lower excess returns in exchange for taking on currency and emerging market risks.
Sajjid Chinoy, Chief India Economist at JPMorgan, has warned that an excessively narrow interest rate spread could negatively impact the exchange rate.
A depreciation of the rupee could drive up inflation in imported goods, particularly if international oil prices remain high.
RBI faces a tough challenge in controlling inflation
Maintaining price stability while supporting economic growth is a primary responsibility of the RBI. Consequently, the central bank faces the challenge of striking a delicate balance.
Although the inflation rate remained above the RBI's 4 percent target, it stayed within the mandated 2–6 percent tolerance band.
The central bank stated that the 'second-round effects'—or indirect impacts—stemming from high food and fuel prices have remained limited. It further noted that there is little evidence of broad-based inflationary pressure arising from current supply-side issues.
However, high oil prices and a strengthening US dollar could further complicate the situation.
India imports a significant portion of its energy needs; consequently, rising global oil prices can exert pressure on the country's import bill, currency value, and inflation levels.
Could the RBI raise interest rates again?
Some economists believe that a further hike in interest rates may be necessary. Soumya Kanti Ghosh, Chief Economist at the State Bank of India, has stated that the RBI might need to take further action in December and has recommended a 50-basis-point rate hike.
At the same time, Ghosh suggested that the central bank could utilize other monetary policy tools rather than relying solely on raising policy interest rates.
One option could be adjusting the 'Marginal Standing Facility' (MSF) rate. The MSF is an overnight lending facility available to banks. Raising the MSF rate can push up money-market interest rates, thereby increasing yields on rupee-denominated assets. This could help make the Indian debt market more attractive to foreign investors.
Following the tax cuts for foreign debt investors earlier in the year, Ghosh has recommended similar tax reductions for long-term foreign equity investors.
Global market conditions may limit India's options.
The RBI's challenges are not limited to domestic inflation and economic growth alone.
High interest rates in advanced economies—particularly the US—can attract global capital toward assets in developed markets. Simultaneously, a strengthening dollar can exert additional pressure on the currencies of emerging markets.
For India, these global forces could create a complex scenario involving currency depreciation, imported inflation, and capital outflows.
Sat Dhura has noted that high yields on assets in developed markets and a strong dollar could compel emerging market central banks to adopt tighter monetary policies—even when lowering interest rates might seem logical based on domestic economic conditions. Consequently, the RBI is left with limited room to maneuver in terms of supporting economic growth while simultaneously protecting the rupee's value and keeping inflation in check.
What the interest rate hike in India means for investors
The RBI's decision to raise interest rates by 25 basis points signals that the central bank is prepared to tackle the pressures on inflation and the currency's value.
However, it is unlikely that this decision alone will reverse the trend of foreign capital outflows.
International investors will continue to monitor several factors, including US interest rates, the strength of the dollar, crude oil prices, corporate earnings, the valuation of Indian assets, inflation, and the rupee's trajectory.
The biggest challenge for Indian policymakers will be striking the right balance between supporting economic growth, controlling inflation, maintaining financial stability, and preventing excessive currency depreciation.
Conclusion
India's recent interest rate hike is providing some support to the rupee and demonstrating the RBI's willingness to take action amidst economic pressures. However, this 25-basis-point increase may not be potent enough to reverse the trend of record capital outflows.
Given the significance of global bond yields, inflation risks driven by oil prices, and persistent pressure on the rupee, the RBI might need to consider further rate hikes or other policy measures.
It will become clear in the coming months whether India's central bank can stabilize the currency and inflation without placing excessive strain on economic growth.
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