Updated: Nov 18, 2019
Take 5 min time and understand it thoroughly
Before its effect, you should know what is the US Fed rate hike?
US Fed is the central bank for the US, like RBI, which is for India. US Fed rate hike refers to the raising (hike) of interest rates that the US Fed is willing to provide to the banks of the US for lending and borrowing activities. This, in turn, increases the interest rates of everything else in the US - of government bonds, or bank savings deposits by customers, of consumer loans, etc. Similar to how when RBI raises or cuts interest rates in India, it affects the interest rates of your loans and deposits (FDs).
So now, How does it affect India?
It primarily affects India by decreasing the value of India’s currency against the US dollar.
In order to understand this, you need to understand the link between currency and interest rates. In general, emerging economies like India have higher inflation and higher interest rates than developed countries like the US and Europe. For example, the interest rates in India right now are around 7–8%, inflation is 5-6% whereas both interest rates and inflation in the US are close to 1-1.5 %.
So a lot of financial institutions raise/borrow money in the US on low-interest rates in dollar terms and then invest that money in government bonds of emerging countries such as India in local currency terms to earn higher interest. Even after taking into account the depreciation of the local currency due to higher inflation, the investors still earn more than what they could have earned had they just kept their money in the US bonds.
Keep in mind that this is a risky investment because the emerging country’s currency and economy is not as stable as that of the US. The investment can quickly lose money if inflation in India rises sharply or the Indian government takes some policy measures which weakens the Indian currency.
Think of it like converting all of your Indian money and putting it in a bank in Nepal to earn their FD interest rate. Anything that affects Nepal now affects your investment.
Now you can imagine what happens when the US raises its domestic interest rates. The difference between interest rates of emerging countries like India and the US decreases, thus making India less attractive for the carry trade. As a result, some of the money (the most risk-averse money amongst all carry traders) exits India and flows back to the US. These investors are selling their Indian investments, converting the rupees they get from the sale to US dollars and sending it back to the US i.e. the demand for dollars has increased while the demand for INR has decreased in the forex market. Result - dollar increases in value while INR depreciates.
Effects of weaker INR i.e. a higher value of US dollar.
The biggest financial institutions (those that hold trillions of dollars in total) are global asset allocators - they invest in everything (stocks, bonds, currencies etc) and every country (India, US, China etc) in proportion to its attractiveness and risks. US bonds are the safest investments on the planet so they form the basis of judging everything.
Now if US fed will raise rate these investors will sell their investment, big outflow will happen and this will drain money from equities and prices will be down.
That's how it works.
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