IMPACT OF FEDERAL RATE HIKE ON INDIA CURRENCY

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 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.
Many FII's borrow money from US Banks and invest in indian markets(equity/debt). As the rise in interest rate, will increase their cost of borrowing.So the FII's will tend to withdraw their money. The continuous selling of investments will have pressure on Rupee as a result it start declining. 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 (something that is known to happen) 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 (eg Rs 72 per USD)
·         More expensive imports eg crude oil -> inflation
·         Good for Indian exporters - but they need to be able to capitalise on it
India imports more goods than it exports by about $100 Bn annually- and the biggest imports are crude and oil related imports which are essential inputs for the entire economy. Increasing price of crude hence means a chance of increasing inflation.

This would also affect RBI’s monetary policy decisions going ahead.


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