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A few events have taken place which imply that there could be significant changes in the interest rate and forex outlook in the next several months.

First, the state of the global macro-economy has changed fundamentally. From being in an era of low global inflation and low interest rates, we are about to enter a period where developed economies are already picking up steam, as we are witnessing in Japan and the US, and inflationary pressures will be felt.

The US Federal Reserve is all but certain to increase rates at its next meeting. Once this happens and we enter a period of rising interest rates, liquidity will get sucked out of emerging markets, including India, and will impact the developing economies in many ways.

We saw that in the 1994 cycle of Fed rate increases as well as in 1997 when, after the Asian crisis, first Russia and then Brazil had to devalue their currencies.

India is vulnerable this time, not because of hot money of the short term debt variety, but more because of the large flows of hedge fund money that have entered the country.

The second big event that will impact India specifically is the policies of the new government. The apprehension is that with a commitment to increase spending in the rural areas and on social sectors such as education and health, the government’s fiscal deficit may balloon.

Thankfully, those running the government’s finances have a fiscally responsible record and the economic team is as strong as could be expected. Third is the oil price. Part of this has been passed on in the recent price increases, and is beginning to feed into the inflation numbers.

Fourth, India’s balance of payments will move into a weaker position mostly because until confidence returns, capital will not. The jury is still out on the government’s reformist tendencies.

In addition, as industrial activity picks up — and all indications are that it will — imports will increase leading to a worsening of the trade deficit.

What does all this mean for the interest rate and rupee? Taking the interest rate first, given that rates are now close to 6 per cent and so is inflation, on a real basis, 10-year rates are still close to zero.

This is not a sustainable position and chances are that as inflation ticks up, interest rates will need to rise further. If the government’s fiscal deficit estimates for the current year — to be announced in the Budget due on July 8 — is based on what the market believes are unrealistic assumptions or is a high number to begin with, then rates are likely to rise in anticipation of the borrowing program. The bank rate may not increase substantially as it is already at 6 per cent.

However, the introduction of turnover tax will have an overwhelming effect in the short term, given the excessive dominance of speculators/traders in the markets on Thursday.

The forex rate is driven by capital flows. We will have to see how confidence in this government develops before being able to make a good assessment.

Given that liquidity is likely to move out of the emerging markets, significant foreign institutional investor money is waiting to exit India at this stage, and Indian companies are likely to raise less money abroad, it is likely that the rupee will remain weak in the short term.

If the government’s policies are eventually viewed positively by the market, then the rupee could strengthen in the medium term. Every thing depends on the government policies and the Budget.

Source: Business Standard