Trial by taper

Indian Express, 13th November 2013

We need to prepare for the end of QE. Keeping inflation low is our best bet.

US job data for October showed higher employment growth than was earlier expected. This good news sets the stage for the US Fed to reduce quantitative easing. However, the uncertainty over the US debt deal means that this may not happen until March 2014. Still, sooner or later, the tapering will start and emerging economies like India have to be prepared for it. The tapering is likely to take a while to complete - it may be a few years before the Fed gets back to a normal monetary policy. For India, this means that the preparation to deal with it must be in the form of a framework of sustainable policies, rather than temporary measures. Low inflation, fiscal consolidation and addressing the structural problems of growth offer sustainable solutions. While quantitative measures and restrictions to control the current account deficit only offer temporary quick fixes.

The market's reaction to the May 22 "tapering speech" by the Fed chairman, Ben Bernanke, was more extreme than anyone had expected. One, long-term interest rates in the US went up immediately and two, capital flowed out of emerging economies (EMs), resulting in the sharp depreciation of their currencies. This was especially the case among those economies that were more vulnerable due to large current account deficits. Many EMs resisted the depreciation, either with an interest rate defence or, as in India's case, with a series of capital controls and other restrictions on foreign exchange markets.

These knee-jerk reactions were often ineffective and in some cases made the depreciation even sharper. Exchange rates overshot and sentiments worsened. It is inevitable that the US Fed will, sooner or later, have to reduce the purchase of government and agency bonds, which it is currently undertaking. Currently, the Fed is purchasing bonds worth $ 85 billion per month. Any signal or action from the Fed - including about whether its bond purchase programme will be reduced gradually or sharply - is bound to affect global financial markets.

There is a strong possibility that the inevitable tapering has already been factored in by financial markets. There is no doubt that the Fed's communication will be far more careful now, so as not to generate expectations that it's going to suddenly end all purchases. US long-term rates have already risen and may remain stable. EM currencies have also depreciated in comparison to their mid-May exchange rates and may not depreciate any further. However, there is, say, a 20 per cent probability that when the tapering actually begins, financial markets will once again see high volatility, US long-term rates will increase and EM currencies will depreciate further.

This time, EMs must not be caught unawares. The question is: how can they prepare for this event? Countries with high inflation, such as India, were the most affected this summer. They also tended to have high current account deficits, as rising inflation with stable nominal exchange rates had rendered their exports uncompetitive, while imports became more attractive. The real appreciation in the exchange rates needed correction, which happened rapidly when there was a sudden reduction in the inflow and increase in the outflow of capital. The depreciation of the nominal exchange rate was, therefore, an adjustment that was on the cards to the extent that it would help correct the current account deficit.

High current account deficits and inflation are, in many cases, the consequences of the expansionary fiscal and monetary policies that were followed by many EMs in the years after the 2008 crisis. In 2009 and 2010, many EMs, including India, in an effort to offset the demand contraction arising from the decline in exports and private investment, implemented expansionary fiscal policies. For example, India cut tax rates and raised spending. This fiscal expansion was accompanied by a loose monetary policy - interest rates stayed too low for too long. Though the RBI raised nominal interest rates, the 13 hikes of 25 basis points each were too little to push up real interest rates, as inflation was rising faster than the nominal rate. This resulted in a further rise in inflation.

In order to prepare for the beginning of the end of quantitative easing, inflation must be brought under control. Global inflation is low. If inflation in India continues to be higher than our partner and competitor countries, as it has been in the years since 2008, there is a high probability that Indian exports will become uncompetitive, imports will become more attractive and the trade deficit will rise. When the tapering begins, the rupee could depreciate suddenly, create balance sheet mismatches for firms that have borrowed abroad, push up oil prices or subsidies and raise inflationary expectations. Countries that have kept inflation under control have less to worry about, due to a smaller impact on their exchange rate and a less adverse effect of a depreciation, were it to occur, on inflationary expectations.

Reducing inflation, in what might be a short window before the tapering starts, is not easy. Inflation has been high and persistent for nearly four years now, and inflationary expectations are heavily entrenched. The RBI governor, Raghuram Rajan, is moving in the right direction by focusing on inflation. This is the sustainable path to reducing the current account deficit and India's vulnerability to a sudden stop in capital inflows. Consumer price inflation in India has been above the RBI's target levels of 5 per cent since 2006. It has been rising ever since, and not enough tightening was done in 2008-09 to pull it back on track. Bringing inflation down will be a slow and painful process. It will be helped by the slowdown in demand because investment has slowed down sharply. The need to raise rates may not be as pressing as it otherwise might have been. However, if savings are to be raised, gold imports to be genuinely reduced (rather than simply re-routed through smuggling) and investment activity revived, low and stable inflation is a necessary condition.