Fighting the taper

Indian Express, 3rd September 2013

Volatility is inevitable. India should prepare its response to the winding up of QE

The dominant theme at the annual meeting of central bankers and economists last week at Jackson Hole, Wyoming, was the impact of Quantitative Easing (QE) tapering on emerging markets (EM). Central bankers from emerging economies pressed Fed officials to consider the volatility in emerging economies arising from changes in the Fed's monetary policy stance. But Fed officials reminded them that their mandate was only to serve the US economy. Emerging markets would have to adjust.

Knowing that the world will be a more volatile place gives us time to prepare. India's policy response to QE tapering should be prepared in advance so that we do not see more of the kind of knee-jerk reactions that were seen last month. It is expected that September may see more forward guidance by the Fed, rather than actual tapering. The pace and timing of the tapering are likely to remain uncertain for many months. This could result in huge volatility in global financial markets. One important question for India will be whether to respond to the pressure on the currency and if so, how.

First, let us look at what lies ahead. The objective of the US Fed's monetary policy is to maintain price stability and achieve maximum employment. The Federal Open Market Committee is responsible for taking decisions on how to achieve these objectives. In normal times, this was done by cutting or raising the policy interest rate. On December 16, 2008 the policy interest rate was cut to the lowest possible level of 0-0.25 per cent. After this, there was no scope of cutting interest rates and the Fed eased monetary policy by purchasing financial assets, thereby stimulating growth, popularly known as QE. The Fed announced its first round of purchases in November 2008 and started buying bonds from March 2009. There have subsequently been two more rounds of QE, in 2010 and then in 2012, as the US economy did not show signs of recovery. The Fed is currently buying $40 billion of Mortgage Backed Securities and $45 billion worth of US treasury bonds per month. Tapering refers to a reduction in the purchase of such securities by the US Fed.

The US economy has recovered slowly in the first half of 2013, with the recovery expected to be faster in the second half. In Q2 2013, the US economy grew at 1.7 per cent. Growth in Q3 and Q4 is expected to be 2.5 per cent. Inflation is around the desired level of 2 per cent. The unemployment rate has fallen from 7.9 per cent at the beginning of the year to 7.4 per cent in July. The Fed has indicated that after the unemployment rate reaches 6.5 per cent, it may consider reducing the pace of its balancesheet expansion.

However, even though the Fed has indicated that it could reduce the pace of monetary expansion, an unemployment rate of 6.5 per cent will not trigger the tapering. One reason is that the US unemployment rate is falling not so much because jobs are increasing, but because of lower labour force participation. Less people say they are actively looking for jobs, something that is likely caused by the long recession. The Fed remains worried that merely a lower unemployment rate may not signal a healthier economy.

Even if the tapering starts in the next couple of months, it will only be the beginning of the process. There will be a reduction in purchases, then stopping purchases and later, at some point, sales of treasuries to reduce the size of the Fed balancesheet to tighten monetary policy. For the last five years, when the Fed was expanding its balancesheet, there was a large flow of capital to emerging economies in search for higher returns. Now the prospect of higher US interest rates is attracting capital back to the US. The top 20 traded EM currencies have depreciated on average 6.8 per cent since May 1, 2013. The depreciation has been most pronounced for countries which need more dollar inflows on the capital account to finance their current account deficits. The currencies of South Africa, India and Brazil have fallen more than 15 per cent against the dollar since May 1, 2013.

Looking forward, the markets may see more capital flow volatility. Flows respond to the probability of the timing and speed of QE tapering, which is estimated by market participants depending on their forecasts about the US economy. When US data is different from these forecasts, this probability changes. This results in inflows and outflows to the US, especially from EMs. This causes high volatility in EM currencies and markets. The data to watch for are those for US jobs growth, labour force participation, inflation, mortgage rates and new home sales, among others.

In August, in the face of acute pressure on the rupee, the government and the RBI valiantly tried to defend it, and reduce the current account deficit. They succeeded only in raising interest rates, increasing capital controls, encouraging gold smuggling, distorting financial markets, creating panic and damaging their respective reputations. Instead of silly policies like duties on flat screen TVs or restricting petrol pump timings to 8am to 8pm, as Veerappa Moily had proposed, the government needs to think carefully about its strategy.

Changing the economy's fundamental weaknesses overnight is nearly impossible. The weaker rupee is, however, good both for current account adjustment and for making Indian assets more competitive. Less friction for foreigners who invest in financial markets should be part of the strategy. It is also very important not to send out wrong signals. Only those short-term policies should be proposed that are consistent with longer term objectives of growth, global integration, rule of law and better financial regulation. The entire cabinet, all ministries, regulators and the bureaucracy must be on the same page about the government's decision to attract foreign capital so that innumerable unnecessary restrictions that are being placed today on foreign investors can be removed. The government must prepare a carefully coordinated, coherent and consistent action plan to adjust to the QE tapering and resulting volatility.