Impact of hike in interest rates by the US Fed Reserve :

I recently read about US monetary policy being important to emerging economies such as India. I tried my best puzzling out the relation between the two, but couldn't. Some pointers towards the link between US interest rates and other economies would be greatly helpful to me.

One of the fundamental factors which decide currency parity is differentials in interest rates of two economies. This enables funds flowing from low rate interest economy / currency to higher interest bearing currency/ economy. Though so many factors have bearing on currency rates, maintaining differentials between 2 countries cause funds to flow.

Now major economies are going thru deflationary situations. Though US went through this, currently their economy has picked up and is on a recovery path. But inflation is still below 2 percent. So US inorder to provide impetus to their economy, had Quantitative Easing program, with concomitant zero interest rate regime. In other words, liquidity is awash in the system and that the funds seek profitable opportunities across the shores. They invest in bonds of those countries , where yields are high. 10 year Indian govt bonds are trading with an yield of about 8.5 percent. ( I think highest in Asia) This has enabled funds to flow into Indian bonds and also to Indian equities, as they perceive it is yielding higher returns.

Hedge funds also short low yielding currencies like USD and invest in high yielding securities, known as 'carry trade'. So they borrow in USD and also short USD and invest in other risky assets. This will continue, so long as, it is yielding them positive returns.

Now imagine, US is already in the process of winding down QE. That is reducing the amount of bonds they buy every month. The next logical process will be increasing interest rates in their economy. Though it is not an immediate threat, as inflation is still below 2 percent in their economy and unemployment is still above 6 percent or so, it is imminent that in2015, sometime in second half, interest rate may witness slow firming up.

For this reason, as well as reasons such as weak euro, USD index DXY has gone up already by 7 percent. But against this, INR has not wilted so far, except with a minor downward adjustment of one rupee or more in INR value against dollar.

The factors which are helping emerging economies is the depressed international oil prices and more for India is restrictions placed by the government in import of gold and depressed international gold prices.

If any of these to change, the result would be FIIs would be pulling their investments in indian equity and bonds, which would put pressure on Indian Rupee. So interest rate increase in US could narrow the interest rate differentials in these 2 currencies, causing INR to depreciate, funds to flow out of our bond/equity markets.