Your Money: Rising interest rates, inflation and currency depreciation

Volatile interest rates are a form of risk for a business.

By Sunil K. Parameswaran

Changing interest rates have many consequences for an economy and the economic agents that operate in it. Let’s consider a situation where interest rates in India go up. This will lead to a higher cost of capital for most companies, since businesses primarily operate with borrowed funds. If the businesses that are affected have adequate marketing power and do not fear a decline in sales, they are likely to pass on the costs to consumers in the form of higher prices for their output. This will manifest itself in the economy as inflation.

Rate dynamics
Volatile interest rates are a form of risk for a business. This can trigger the use of interest rate derivatives such as forward rate agreements, interest rate futures and options, and swaps, by both hedgers who are seeking to avoid risk and speculators who are seeking to profit from the increased risk.

If interest rates in India go up, foreign portfolio investment will increase. This will lead to an increased demand for the Rupee and an increased supply of currencies such as the US Dollar and the Euro. Consequently, the Rupee will appreciate. Imports will become cheaper for Indians, and Indian products and services will become less competitive in the global market.

India’s current account deficit will widen as a consequence. Indian products will become relatively expensive for Indians due to an appreciating rupee and increasing domestic inflation. This could lead to substitution of domestic products with foreign imports, which will exacerbate the current account deficit.

Rising rates
Rising inflation is a self-fulfilling phenomenon. If people anticipate higher inflation they will demand higher prices for factors of production like land, labour and capital. The anticipation of higher prices will lead to higher prices. In practice, this is hard to control, and is termed an inflation spiral.

If the interest rates in a key partner country were to rise or fall, there will be consequences for India. If money supply is tightened in the US, capital which would otherwise be destined for India, would get routed to the US. There will be increased demand for the US dollar and the rupee, like other currencies, will depreciate. Software and pharma exporters in India would stand to benefit, while Indian importers will have to pay a higher price for products imported.

Foreign portfolio investment is likely to slow down due to the redirection of capital to the US. This will reduce the demand for the rupee and manifest itself as a depreciating rupee. High net worth investors in India may prefer to invest abroad, within the regulatory framework specified by the Reserve Bank of India. This too will lead to a higher demand for foreign currencies and a depreciation of the rupee. Reduced demand for Indian debt products, will depress their prices, causing domestic yields to increase.

In a rising inflationary environment, labour will demand higher wages. This could lead to greater automation of production processes to cut costs. Higher wages mean a higher cost of production for companies and will usually result in higher price levels. The Phillips curve in Economics postulates an inverse relationship between inflation and unemployment. If most of a country’s workforce is absorbed in productive activities, the economy will be operating at close to full capacity and price levels will rise. In a recessionary atmosphere, unemployment will be high and inflation rates will be low.

The writer is CEO,
Tarheel Consultancy Services