Executive summary

In this insight, we analyse how sensitive India is to changes in monetary policies of other economies, in particular the US.

This study is done against the backdrop of changes in economic thinking regarding the influence of monetary policies on global financial cycles. Recent cross-country evidence has shown that the monetary policies of advanced economies, especially the US, affect not only capital flows to emerging markets and their exchange rates, but also asset prices, credit growth and leverage in these economies. The impact has amplified after the 2008 crisis, when major central banks adopted unconventional monetary policies. In this insight, we study this evidence specific to India.

We find that the impact on India has not been as widespread as what cross-country evidence has shown. The variables most affected by US monetary policy stance were short-term capital flows, India’s overseas borrowing, and credit spreads. However, rupee movements, long term capital flows, domestic monetary policy, government securities, and domestic credit growth did not follow much the changing US policy for most of the period post 2008.

In fact, rupee depreciation was lower, foreign direct investment higher, and domestic rates lower when the US Federal Reserve (Fed) tightened its stance post 2013.

However, significant exceptions to these trends were the years 2013 and 2018, when most of these variables were adversely affected by US monetary tightening.

We find that the extent of impact has depended on domestic vulnerability. India’s vulnerability was reducing for most of the period when the Fed was tightening monetary policy. This reduced the adverse impact of tightening global financial conditions on India during that time.

The importance of domestic vulnerability is also underscored in our experience in the years 2013 and 2018, when India got adversely impacted by the US Fed’s monetary policies. India was highly vulnerable these years, which allowed the adverse impact to get transmitted to the economy.

Viewing from this lens, how is the external environment expected to affect India in near term?

Global monetary environment is expected to remain benign at least till next year. However, there is also significant geopolitical uncertainty, which is affecting risk appetite. India’s own vulnerability has also shown some sign of weakness of late with slowing GDP growth and rising fiscal stress.

This could result in volatile foreign capital inflows, especially of short-term nature like FPIs. In such a scenario, it is critical for India to maintain macroeconomic prudence and improve fundamentals.