A simple explanation of Interest Rate Parity, why it doesn't always hold cleanly in practice, and what that meant for the rupee and Indian equities in 2022.
Tejas Shah
Proprietor of Silicon One and Silicon Systems, AMFI-registered Mutual Fund Distributor since 2004, based in Vadodara.
Interest Rate Parity (IRP) is a theory stating that the interest rate differential between two countries should equal the differential between the forward and spot exchange rates. In theory, if Country 1's rate is 2% and Country 2's is 6%, you could borrow at 2%, invest at 6%, and pocket a risk-free 4% — a gap markets should quickly arbitrage away.
Why it didn't hold cleanly in 2021-22
Between 2021 and 2022, the US-India interest rate differential narrowed from roughly 4% to 2%, yet the rupee still depreciated by about 9% against the dollar — the opposite of what a narrowing differential alone would predict. A major reason: a rapid outflow of dollars from India meant a US investor earning 12% in Indian equities, minus a 9% currency loss, was left with only about a 3% net return — not attractive next to rising US and UK government bond yields of 4-5% with none of the currency or market risk.
The knock-on effect for Indian markets
If the RBI raises Indian interest rates to widen the differential again, it also raises FD rates, government bond yields and liquid fund yields — making domestic investors more likely to shift from equity into debt, especially with equity valuations already elevated. Rising cost of capital is rarely good for equities: India has a strong long-term growth story, but in the short-to-medium term, sustained capital outflows can still force a correction.
There's a time to be opportunistic, and a time to be cautious — choose wisely. Happy investing! — Tejas Shah
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