Economy weathers a storm, but more turbulence lies ahead

India has been managing quite well despite the recent economic storm caused by the West Asia war-induced energy supply shock. However, there are concerns that more turbulence may be on the horizon due to soaring global long-term interest rates.

In Japan, ten-year government bond yields crossed the 3 percent mark this week for the first time since 1996. Similarly, the US and the UK saw their ten-year bond yields hit 4.8 percent and 5.2 percent, respectively. The 30-year bond yields for these countries are even higher at 4.1 percent, 5.3 percent, and 5.9 percent, respectively. Given that these are risk-free investments issued by debt-free governments, the implications are significant.

If investors can earn a guaranteed 4.8 percent return on US treasuries, why would they invest in India? As a result, Indian banks offered interest rates ranging from 6 to 6.5 percent on Foreign Currency Non-Resident (Bank) deposits, mobilized $127.2 billion between June 8 and August 21, with the Reserve Bank of India bearing the cost of hedging against currency fluctuation through a special dollar-rupee swap facility.

This action transferred the risk of rupee depreciation to the RBI, allowing banks to pay such high interest rates on these foreign currency deposits. However, there is a cost involved in this arrangement, as the value of foreign money is no longer cheap.

Given the prevailing global bond yield trend, this situation may become even more expensive for India. The attractiveness of India's growth prospects, reflected in its equity markets, may not be enough to lure substantial long-term capital from foreign investors in today's environment with elevated bond yields.

To build economic resilience, India needs to focus on macroeconomic stability and boost exports. In a rising interest-rate environment, governments cannot afford to run high fiscal deficits, which would further crowd out private-sector and productive borrowings. They should also avoid increasing current account deficits, which would be difficult to finance when global capital flows become volatile.

The RBI's special forex swap window, like the one used for FCNR(B) deposits, can provide a temporary reprieve to India's external sector. However, this cannot replace more durable interventions such as fiscal consolidation, promoting exports through increased global market access, eliminating duties on imported raw materials and components, and ensuring policy stability and predictability for foreign investors.