The US bond market has been witnessing a sharp rise in yields, as investors anticipate higher inflation and interest rates in the world’s largest economy. The 10-year Treasury yield, which is a benchmark for global borrowing costs, has surged to nearly 5%, the highest level since 2021. This has also boosted the value of the US dollar, which has appreciated by about 3-4% against a basket of major currencies in the past month.

These developments have significant implications for emerging markets, especially India, which is one of the largest borrowers of foreign capital and one of the most vulnerable to currency fluctuations. In this article, we will explore how the rising US bond yields and dollar appreciation can affect India’s economy and financial markets, and what strategies can help mitigate the risks.

The Impact of Rising US Bond Yields and Dollar Appreciation on India

The rising US bond yields and dollar appreciation can have both direct and indirect effects on India’s economy and financial markets. Some of the possible impacts are:

• Higher cost of external borrowing: India has a large external debt of about $570 billion, of which about 37% is denominated in US dollars. As the US bond yields and dollar appreciate, the cost of servicing this debt increases, putting pressure on India’s fiscal and current account deficits. Moreover, higher US interest rates can reduce the availability and attractiveness of foreign capital for Indian borrowers, especially in the corporate sector, which relies heavily on external commercial borrowings.
• Lower capital inflows and foreign exchange reserves: India is also dependent on foreign portfolio inflows to finance its current account deficit and support its equity and bond markets. However, as the US bond yields and dollar appreciate, foreign investors may shift their funds from emerging markets to safer and higher-yielding assets in the US. This can lead to capital outflows from India, weakening its currency and depleting its foreign exchange reserves. According to a recent report by Nomura, India is among the most vulnerable emerging markets to capital outflows due to its high external financing needs.
• Weaker domestic demand and growth: The rising US bond yields and dollar appreciation can also have a negative impact on India’s domestic demand and growth. A weaker currency can increase the cost of imported goods and services, such as oil, gold, electronics, etc., leading to higher inflation and lower purchasing power for consumers. Moreover, higher interest rates can dampen investment and consumption demand, especially in interest-sensitive sectors such as housing, automobiles, consumer durables, etc. This can slow down India’s economic recovery from the pandemic-induced recession.
• Higher volatility and uncertainty in financial markets: The rising US bond yields and dollar appreciation can also increase the volatility and uncertainty in India’s financial markets. A weaker currency can erode the value of foreign investors’ holdings in Indian assets, prompting them to sell or hedge their positions. This can create downward pressure on India’s equity and bond prices, as well as widen the spreads between corporate and sovereign bonds. Moreover, higher volatility can reduce investor confidence and sentiment, leading to more risk aversion and lower liquidity in the markets.

How to Mitigate the Risks of Rising US Bond Yields and Dollar Appreciation

Given the potential challenges posed by the rising US bond yields and dollar appreciation, India needs to adopt a proactive and prudent approach to manage its external vulnerabilities and maintain its macroeconomic stability. Some of the possible measures are:

• Strengthening fiscal discipline: India needs to adhere to its fiscal consolidation path and reduce its fiscal deficit and public debt levels. This can help improve its credit rating and credibility among foreign investors, as well as create more fiscal space for counter-cyclical measures in case of a shock. Moreover, India needs to enhance its tax revenue collection and rationalize its expenditure priorities, especially on subsidies and social welfare schemes.
• Boosting domestic savings: India needs to increase its domestic savings rate, which has declined from about 36% of GDP in 2008 to about 30% in 2020. This can help reduce its dependence on foreign capital inflows and improve its current account balance. Moreover, India needs to encourage more financial inclusion and formalization of the economy, as well as promote more long-term savings instruments such as pension funds, insurance products, etc.
• Diversifying external sources of funding: India needs to diversify its external sources of funding beyond US dollar-denominated debt. This can help reduce its currency mismatch risk and exposure to US interest rate movements. Moreover, India needs to tap into alternative sources of financing such as multilateral institutions, sovereign wealth funds, diaspora bonds, etc., as well as attract more foreign direct investment (FDI) into productive sectors such as infrastructure, manufacturing, etc.
• Maintaining exchange rate flexibility: India needs to maintain a flexible exchange rate regime that allows the currency to adjust to market forces and reflect its underlying fundamentals. This can help absorb external shocks and enhance the competitiveness of India’s exports. Moreover, India needs to avoid excessive intervention in the foreign exchange market, except to smooth out excessive volatility and prevent disorderly movements. India also needs to build up adequate foreign exchange reserves to cushion against sudden capital outflows and currency pressures.
• Enhancing monetary policy credibility: India needs to ensure that its monetary policy is credible and consistent with its inflation-targeting framework. This can help anchor inflation expectations and reduce the pass-through of currency depreciation to domestic prices. Moreover, India needs to maintain a positive real interest rate differential with the US, as well as ensure adequate liquidity and transmission of policy rates in the financial system.

To conclude, the rising US bond yields and dollar appreciation poses a significant challenge for India’s economy and financial markets, as they increase the cost and reduce the availability of external financing, weaken the domestic demand and growth, and create more volatility and uncertainty in the markets.

However, India can mitigate these risks by strengthening its fiscal discipline, boosting its domestic savings, diversifying its external sources of funding, maintaining its exchange rate flexibility, and enhancing its monetary policy credibility. These measures can help India maintain its macroeconomic stability and resilience in the face of external shocks.

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