India's natural interest rate is expected to remain stable, though narrowing gaps with US bond yields pose risks to foreign capital inflows, prompting the need for stronger export-led growth strategies.
India's Natural Interest Rate Outlook
India's natural interest rate is likely to remain stable despite rising interest rates in developed economies. However, the narrowing gap between Indian and US bond yields could make it difficult for India to depend on foreign investments to finance its current account deficit, according to a study by SBI Capital Markets. The report said India's interest rate drivers were more stable than those in the United States, where the natural rate of interest is expected to move higher due to rising government debt, increased borrowing costs and changes in global investment flows.
Understanding the Natural Rate of Interest
The natural rate of interest, or r*, is the theoretical rate at which an economy can grow at its full potential while keeping inflation stable. It influences borrowing costs and government bond yields over the longer term. The report said India's stable growth outlook and anchored inflation expectations were supporting its natural rate, while gradual fiscal consolidation, an improving credit profile and a recovery in household savings could also provide stability. These factors are expected to offset some upward pressure from higher global interest rates and sustained domestic investment. "Thus, Indian r*, while subject to quarterly variations due to timing differences between the moving parts, need not necessarily rise like the US," the report said.
Impact of US Economic Trends
The study noted that inflation-driven interest rate increases accounted for around 75-85 per cent of the rise in US Treasury yields since mid-2020. It added that rising government borrowing, concerns over US creditworthiness and overseas investors diversifying into non-dollar assets were likely to put further upward pressure on US interest rates. For India, the changing interest rate differential could have implications for the country's external finances.
Strategies for External Finances
The report said the gap between inflation in India and the US had narrowed over the past decade, reducing the difference in policy rates and government bond yields between the two economies. As a result, the large foreign capital inflows that previously helped finance India's current account deficit may become less dependable, particularly as the yield advantage offered by Indian debt narrows. To address this, the report suggested strengthening export-led growth to improve the merchandise trade balance, encouraging foreign investors to return to equity markets and maintaining adequate foreign exchange reserves to support currency stability. The report further said these measures would become increasingly important in managing India's balance of payments as global interest rate conditions evolve.
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