As widely expected, the US Federal Reserve decided to hike its benchmark rates by 25 basis points. The statement also suggested that future hikes will be gradual. A small hike, combined with a dovish statement, is not unreasonable for an economy where the unemployment rate has fallen to 5%. Yet, several commentators seem concerned that this could make capital too expensive for the global economy, especially struggling emerging markets.

The question is — will even small interest rate hikes by the US Fed make global capital expensive over the next year? In order to answer this question one must first recognise that the real source of cheap capital (and deflation) in the world is not the United States but China. The Asian giant singlehandedly accounts for more than a quarter of all the world’s investment and savings. Its dominance is driven by the fact it saves and invests almost half of its 11-trillion economy. The problem is that such an investment effort cannot be sustained in an economy that has brand new infrastructure and suffers excess capacity in almost every sector. Moreover, its workforce is now shrinking and the new services sectors simply need less capital.

The dynamic is already visible: China’s domestic investment rate declined from 47% of GDP in 2011 to 44.3% in 2015 ( IMF estimate). Given the experience of former investment driven economies like Japan, it is reasonable to expect this rate to drop to somewhere in 35% range over the next decade. However, the experience of rapidly aging societies also shows that the savings rate will not decline quite so quickly. We have already seen this in China with the savings rate falling only from 48.8% to 47.4% between 2011 and 2015. In other words, rising consumption will not fully compensate slowing investment.

For China’s domestic economy, this means that GDP growth rate will steadily drift down even if the authorities manage to smoothen the transition. The important implication from a global perspective is that the persistent gap between China’s savings and investment rates will generate excess savings that will show up as large current account surpluses. Indeed, the surplus has already jumped from 136 billion in 2011 to an estimated 348 billion in 2015. In turn, this surplus will flood the world as capital outflows (i.e. Chinese investments in other countries). This could happen through direct investments or indirectly through institutions like the Brics Bank and Asian Infrastructure Investment Bank.

The pipeline of cheap capital from China is potentially so large and persistent that it could hold down the cost of long-term global capital even if the US Fed keeps tightening. As the world economy is a closed system, someone will have to run a deficit in order to absorb the excess savings being generated by China. The emerging economies just do not have the scale necessary to absorb such large sums. Europe has the scale but does not seem to be in a position to ramp up spending. The best we can expect is that it does not add to the problem by generating its own surpluses. This brings us back to the US. It is still the world’s largest economy and its investment rate has barely climbed back 20% of GDP this year. Therefore, theoretically it could ramp up its investment effort and absorb the excess capital (a consumption binge would also achieve this although one hopes that lessons have been learned from pre-2007 period).

Infrastructure is the most obvious sector that could absorb large amounts of capital. The US now has arguably the worst infrastructure of any major developed country; some of it is poor even by emerging market standards. The problem is that most infrastructure ultimately needs government spending and the US government is not likely to go on an investment spree. Gross government debt now stands at 104% of GDP and is refusing to decline despite the revival in growth. Political hurdles will also hold down infrastructure spending in 2016. Higher rates will certainly not help the case.

In other words, the cost of long-term global capital will only rise if the US absorbs most of the excess savings emanating from China.

Unfortunately, short of yet another debt-fuelled consumption binge, the US looks unlikely to absorb enough capital. If the Fed keeps hiking rates under these circumstances, we will have a stronger dollar but not necessarily higher long-term rates for the rest of the world.

In fact, it could potentially cause deflation that would allow counties like India to reduce interest rates further. If as a result the rupee keeps declining along with other currencies against the dollar, so be it. Even China is increasingly managing its exchange rate against a basket.

To summarise: the world economy will only generate growth by reverting to large global imbalances. In such a situation the US will be again sucking in a large quantum of imports from the rest of the world. The alternative is that the world economy continues to drift in limbo due US economy’s unwillingness to run the necessary deficits. However, global capital will remain cheap in this circumstance. Both outcomes offer opportunities for India.