After a steady rise for over two years, Indian markets have been in a correction phase since October 2024. Equity markets have declined by 14 percent; the exchange rate has depreciated by 4 percent; the reserves have declined by $65 billion (9 percent of the stock that existed); while FII investors have pulled out nearly $23 billion from the equity and debt markets.
Painful as it seems, the current sell-off is not a one-off phenomenon. Nor is it unique to India. Similar episodes of risk aversion and portfolio rebalancing out of Emerging Markets (EMs) have been occurring every two years, adding up to six such episodes during the last decade – in 2013, 2016, 2018, 2020, 2022, and 2024.
Significantly, four of these episodes have coincided with policy or political developments in the US, pointing to its influence on EMs.
The first sell-off occurred in 2013 (Taper Tantrum), when then Federal Reserve Chairman Ben Bernanke announced the Fed’s intent to reverse the pace of its ultra loose monetary policy. It resulted in an exodus of capital flows from EMs, a sharp depreciation of their exchange rates, decline in equity markets, and increase in bond yields.
The EMs faced similar shocks in 2016 after the election of President Trump; in 2018 when the US pressed the pedal on tariffs on China to which Beijing retaliated; in 2020 when COVID struck; and in 2022 when the Ukraine-Russia war broke out. The latest episode started in early October, when the Fed’s guidance on policy rate was reset to “higher for longer”, and built up as Trump’s disruptive trade agenda started taking shape.
India was one of the five most impacted economies during the first sell-off in 2013, when its exchange rate depreciated by 25 percent, reserves declined by 6 percent, and equity markets by 9 percent. In 2018, its exchange rate depreciated by 15 percent, reserves declined by 8 percent, and equity markets by 3 percent. In 2022, its exchange rate depreciated by 10 percent, reserves declined by 16 percent, and equity markets by 13 percent.
There are several similarities across these episodes.
First, the impact across countries has less to do with their economic strength, and more to do with the presence of reversible capital, the ease with which this capital can be withdrawn, and the extent of overvaluation. Thus, while strong macroeconomic fundamentals do not insulate India, the extent of reversible capital, its large and liquid markets, and potential overvaluations make it a fertile ground for these reversals.
Second, these events are short-lived, each lasting only a few months. The reprieve starts as soon as valuations become attractive and EMs appear competitive again.
Third, despite initial trauma, they do not leave a trail of destruction. Domestic financial sectors remain resilient to them, neither do they result in economic slowdowns.
Finally, the existing policy frameworks enable countries to respond promptly and adequately to them. Dealing with them does not necessitate any drastic measures including any assistance from the IMF. Countries are able to leverage flexible exchange rates, pool of forex reserves, prudent banking regulations, robust fiscal architecture, and credible monetary policy frameworks (e.g. inflation targeting) to handle them.
Past experiences, thus, suggest that the current storm too shall pass soon, without causing grave damage. Meanwhile, the next one may not be too far on the horizon.
How may India prepare both ex ante and ex post, for future shocks?
For ex ante measures, India should encourage stable, longer-term capital inflows (such as FDI) over volatile short-term flows (like FII flows). It should rebuild its reserves buffer as soon as the conditions turn conducive. While avoiding excessive appreciation or volatility of the exchange rate, it should still let it move more than has been the case in the recent past.
To soften the impact ex post, a fine calibration of exchange rate depreciation and use of reserves is needed. In recent years, policy response has shifted more toward the use of reserves while limiting the depreciation of the exchange rate. This ought to be revisited for speedier mitigation of the shocks.
It would also help to re-assert the commitment to reforms, macroeconomic stability, and growth in such risk-off times. Equally important is to avoid any policy mis-steps, such as new forms of capital controls (as per the experience in 2013), and adopting a clear communication strategy with the market participants. Occasionally, swap lines with specific countries (particularly Japan) may be renewed; and schemes aimed at attracting funding from the Indian diaspora could be reintroduced.
These events serve as reminders that having graduated to the class of a large emerging market, India needs to remain vigilant, prudent, communicative, and committed to reforms, growth, and macroeconomic stability at all times.
The writer is Director General, NCAER. Views are personal.
