Facing Fed rate hike, confident India predicts investors will keep calm and carry on

Two years ago India was a "fragile five" emerging economy growing at five per cent, grappling with a severe current account deficit, near double-digit inflation, and the rupee at record lows as the US Federal Reserve prepared to taper its stimulus programme.

Today, two years into the term of Reserve Bank of India (RBI) Governor Raghuram Rajan , the rupee has shrugged off its taper tantrum, inflation is tamed, and India has lifted foreign investment limits to confidently face the Fed's first rate rise since 2006.

Officials familiar with the bank's thinking say investors are expected to take profits out of emerging markets when the Fed raises interest rates, but they also expect investors to return swiftly to India which Governor Rajan has called "an island of relative calm" among emerging markets.

From "fragile five" to "island of calm" marks a major turnaround under Rajan, whose term is due to end next year. In the months before he took office, the Fed's taper plan had sparked the RBI's worst currency turmoil since the 1991 balance of payments crisis.

The "fragile five" big emerging economies comprising India , Brazil, Indonesia, Turkey and South Africa were seen to be at high political and monetary risk from the Fed's taper plan, which was completed in late October last year.

The Fed funds rate around 0.13 per cent has encouraged heavy investment in higher-yielding emerging markets, but when the Fed raises rates, seen by end-2015 or early next year, emerging markets are expected to experience a massive outflow of dollars returning to the United States.

"After the initial reaction, investors will factor in India's macroeconomic fundamentals which are better than many countries," said one official, who declined to be identified.

"Investors will initially book profits in countries which are attractive, to offset losses. But after that they will again come back to those countries which earned them profits."

Analysts and the officials familiar with the RBI say confidence was behind last week's move to cut interest rates by a steeper-than-expected 50 basis points, but also to raise limits on overseas investment in government debt.

Many analysts had expected the foreign investment limit to be lifted after the anticipated US rate rise, to avoid significant outflows. But officials said the decision to press ahead was about increasing predictability and confidently attracting more investment to India's young and shallow debt markets.

"One can't wait forever for the Fed to raise rates and hold back market development measures," the official said.

"Interest rates have already been lowered, so the arbitrage opportunity that usually attracts short-term flows is less. Therefore, more genuine and long-term foreign investors are expected to buy Indian debt."

RESERVES OF CONFIDENCE

India was less directly affected by the Chinese stock market rout and yuan devaluation that battered currencies and markets in the region.

It draws considerable confidence from foreign exchange reserves just off record highs at $350 billion, enough to cover nearly 10 months of imports, from a low of $274.8 billion in September 2013.

Nagaraj Kulkarni, senior rates strategist at Standard Chartered in Singapore, said he expected India to be resilient when the Fed raises rates.

"From a foreign investor perspective India offers a very good risk-reward ratio," he said, "so we expect foreign investor interest in India to continue."