Unlike in 2013, this time India is far less vulnerable and a sudden pull out of foreign funds is unlikely
There is uncertainty of how markets will react to the inevitable US monetary policy normalisation. And in emerging markets (EMs) there is fear of a repeat of the infamous taper tantrum when Ben Bernanke’s announcement of reduction in Fed market purchases led to a rush of foreign portfolio flows (FPI) out of EMs back to the US.
The Fed on its part was only preparing markets for exit by announcing the taper date some months ahead. The reaction was extreme, however, because it was interpreted as coming inevitably despite evolving conditions. By contrast Janet Yellen as Governor was able to raise rates without any adverse reaction.
She was careful to be data driven, linking changes to improvements in employment etc. Also the action was more on rates than on liquidity. Additions to liquidity were discontinued but existing stocks were to shrink naturally and slowly as securities matured. These lessons have been learnt and the Fed is now much more data led and has regular discussions with markets also.
Effect on India
While surges and sudden stops in EM capital flows are largely due to global risk-on and risk-off, conditions in specific countries also matter. India has both less vulnerability and more promise than it did in 2013 when large double deficits and other macroeconomic vulnerabilities put it in the fragile five among EMs. Today it is the country that promises the highest potential growth among EMs. Capital is unlikely to want to lose out on that possibility.
Moreover, debt flows that are the most volatile, and the most susceptible to a turn in the US rate cycle, have already left. They are around 2 per cent of India’s domestic turnover, compared to the permitted 6 per cent. The share of the more stable FDI has risen.
Caps for different types of capital inflows that rise with domestic market deepening are a part of India’s careful sequenced capital account convertibility. Diversification is the best way to sterilise shocks and it implies foreign inflows should not dominate any segment. Opposite views and strategies make markets more stable. They protect from the one-way movements and excess volatility inherent in finance. It is true deep markets make exit easy since the market impact is less. But other participants find opportunities in the dips created.
In 2013 among the various defence measures the RBI adopted, the sharp rise in rates had no effect on debt outflows or on the rupee and only deepened the slowdown. The result was similar in 2018 when rates were raised in sync with the US Fed. What worked to reverse rupee depreciation in 2013 was the swap used to make dollars available to Indian oil companies, since it alleviated dollar scarcity in the market.
Reserves are accumulated to provide security against such episodes, but many central banks are reluctant to use them. Whatever the level or reserves, it tends to become a threshold, since markets tend to regard any reduction as a sign of weakness and unravelling.
Reserves must be used, however, so that two-way movement becomes accepted. But strategic intervention and timing based on deep knowledge of Indian markets can allow for maximum impact with minimum expenditure of reserves.
It is best to allow some depreciation immediately, so that outflows make losses, before bringing on the big guns. Some rupee volatility also encourages hedging.
In the long run the market is the best at discovering price and has kept the Indian exchange rate at around equilibrium levels after correcting for differential productivity growth and other structural features, although there is real appreciation beyond the level set in the early nineties. But there can be large short-run deviations due to surges in capital flows. So intervention is necessary. Capital flow management (CFM), such as caps on market share or asset share, is also an essential complement to intervention. Otherwise the RBI can end up holding US treasuries that pay little while helping foreign capital earn high returns from investing in Indian government securities.
Moreover, if foreign securities dominate the RBI balance sheet, it is forced to reduce its acquisition of Indian government securities and support to government borrowing requirements.
In addition, if market intervention persistently exceeds 2 per cent of its GDP the US treasury threatens to label a country as a currency manipulator, although US quantitative easing and the absence of prudential regulation of non-banks flows are responsible for surges in capital flows. Emerging markets must take up these issues in the G-20 and IMF.
The IMF now supports CFM but advises restrictions on its pre-emptive use before other measures. This limits usefulness. Prudential measures used for financial stability are also sometimes labelled as CFM. Market over-reactions make it difficult to reverse freedoms given and to impose sudden restrictions in crisis times. Transparent, pre-emptive and pre-announced countercyclical measures are better. Crisis time CFM is unlikely to be used. EMs bear most of the costs of prudential measures since they use them much more than AEs do. More action is required from source countries.
Reserves offer security but at a high opportunity cost. Since they are largely built from capital flows that are borrowed they have to be kept in a liquid form that preserves capital, but earns little.
The best way to use them is to prevent global shocks from disturbing the domestic cycle, so that physical investment rises and absorbs inflows productively. Causality from the capital account (KA) to the current account (CA) of the balance of payments indicates disruption from capital flows while the reverse can indicate smooth financing of the CA that allows investment to exceed domestic savings.
Our research (https://journals.sagepub.com/doi/pdf/10.1177/0015732518810832) finds only indirect causality through some components. Of the capital flow components only foreign direct investment (FDI) affects gross fixed capital formation (GFCF). The latter consistently affects the CA. The CA affects debt portfolio flows and non-resident deposits, suggesting these were used to finance the CA, but they did not affect GFCF. Volatile flows therefore did not deteriorate the CA, but they also did not contribute to GFCF. India’s gradual capital account convertibility may have mitigated shocks from the KA. Long-term sustainability, however, requires FDI to increase compared to other types of flows.
The writer is Emeritus Professor, IGIDR