Is India safe from US Fed’s tapering spree? Arvind Panagariya decodes – The Economic Times

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Why should India and other emerging market economies (EMEs) care what the US does to its money supply? The short answer is that in an environment in which capital moves swiftly to whichever destination offers it higher returns, any significant change in the world’s largest economy can have profound effects on other, smaller economies of the world.

Arvind Panagariya

Arvind Panagariya

The writer is Professor, Columbia University, USRecognising the threat to the economy from Covid-19-induced disruptions, the US Federal Reserve had embarked upon a sustained monetary expansion beginning in March 2020. With the inflation rate having climbed up to a 40-year high and the unemployment rate having fallen to a historic low, Fed Chairman Jerome Powell has decided to unwind this expansion. On December 15, he announced that he would decelerate monetary expansion, bringing it to a stop in March 2022. He further announced that he expected to raise the policy interest rate three-quarter percentage point by the end of 2022. Known as the federal funds rate, the latter is the interest rate at which commercial banks lend their excess reserves to each other overnight.

Why should India and other emerging market economies (EMEs) care what the US does to its money supply? The short answer is that in an environment in which capital moves swiftly to whichever destination offers it higher returns, any significant change in the world’s largest economy can have profound effects on other, smaller economies of the world.

A slowdown in US monetary expansion amounts to a slowdown in the purchase of US bonds by the Fed. This, in turn, has the effect of lowering the prices of US bonds, making them a more attractive asset for investment relative to other assets. In response, investors begin to liquidate other assets to move into US bonds.

These ‘other assets’ include EME bonds and stocks. To move out of them, investors liquidate them, convert the proceeds from local currency into dollars and invest them in US bonds. These transactions have two effects: sales of EME bonds and stocks lower their prices, and the conversion of local currency into dollars depreciates the former against the latter. The depreciation may, in turn, fuel inflation by making imports more expensive in local currency.

How large can this effect be? With the value of its stocks, bonds and money supply at about $30 trillion, $40 trillion and $20 trillion respectively, such movements have, at best, limited impact on the US economy. But they can have significant effects on the much smaller EMEs.

When the Bond Fell
An earlier episode of deceleration of a monetary expansion by the US – tapering – illustrates the point. In response to the 2008 global financial crisis, the Fed had embarked upon a multi-year monetary expansion. On May 22, 2013, then Fed chairman Ben Bernanke happened to suggest during a Congressional testimony that continued sustained improvement in the economy could lead him to ‘take a step down in our pace of purchases’ of US bonds.

That suggestion alone proved sufficient to send the US bond prices into tailspin. Alongside, investments in financial assets, especially equities, saw an exit from India into US bonds. Equity prices in India fell and the rupee depreciated from ₹55.70 per dollar on May 23, 2013, to ₹68.81 by August 28, 2013.

Will we see a replay of 2013 in the current tapering episode? Unlikely. For starters, in the earlier episode, even after five years of sustained monetary expansion, unemployment had remained high at 7.5% and inflation low at 1.5%. Therefore, the Bernanke statement took markets by surprise. This time around, recovery has been robust, with unemployment rate low at 4.2% and inflation high at 6.8%.

Powell’s announcement is in line with market expectations. Indeed, he had already prepared the ground for the announcement by indicating on November 30 that tapering could wrap up ‘a few months sooner’ than anticipated and that ‘it’s probably a good time to retire’ the word ‘transitory’ to describe inflation.

Even bigger differences exist at the Indian end. At the time of the Bernanke tapering announcement, India already faced a high rate of inflation and a large current account deficit (CAD). Moreover, contrary to India’s own long-standing practice, the Reserve Bank of India (RBI) had adopted a policy of no intervention in the foreign exchange market. Therefore, when Bernanke’s remarks triggered the exit of capital and the rupee went into free fall, its intervention was half-hearted.

Even then, in the first month, the fall in the value of the rupee was not alarming – from ₹55.70 per dollar on May 23, 2013, to ₹60.70 on June 25. In the following month, it fluctuated without trend and still traded at ₹59.60 on July 23. But, then, speculation on the reintroduction of restrictions on certain forms of capital outflows and generally poor communication with the markets in the middle of a transition to the new leadership at the top at the RBI rattled investors. They once again began moving funds in large volumes out of India, with the result that the rupee depreciated further to ₹68.80 per dollar by August 28, 2013.

On a Good Wicket
Today, macroeconomic indicators exhibit greater stability with low inflation and low CAD. More importantly, RBI has the benefit of the experience gained in 2013.

Consequently, it is significantly more vigilant on communication. It stands ready to intervene aggressively in the foreign exchange market to smooth out short-term fluctuations in the value of the rupee. And with foreign exchange reserves in excess of $625 billion, it is fully credible in its interventions. So, tapering this time around need not be India’s worry.

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