National Council of Applied Economic Research
Opinion: Poonam Gupta
India should maintain an appropriate level of reserves avoid excessive volatility of the exchange rate and prepare banks and firms to handle greater volatility.
In recent months tapering seems to have become the buzzword again.’Tapering’ refers to the phenomenon when the central banks of advanced countries particularly the US Federal Reserve Board (FRB) start withdrawing liquidity and how this action – or its anticipation – impacts emerging markets. The first time we saw it was in 2013 when Fed chairman Ben Bernanke mooted the possibility that the FRB may begin to reduce its asset purchases. The announcement resulted in a large en masse exodus of capital flows and a sharp negative impact on exchange rates and financial markets in emerging markets.
While nearly 30 countries were impacted during this ‘rebalancing episode’ the maximum impact was felt in five of them – the ‘Fragile Five’. India belonged to this group along with Brazil Indonesia South Africa and Turkey. The average exchange rate depreciated by 9% while the equity price declined by 5%. Foreign reserves declined by 7% and the average bond yield increased by more than 50 basis points (bps) in the Fragile Five.
Taper to Torpor?
The largest exchange rate depreciation occurred in Brazil the largest decline in stock prices in Turkey and the largest reserve loss in Indonesia. India had the second-largest exchange rate depreciation (nearly 16%) and the second-largest decline in reserves (about 6%).
Central bankers scrambled to contain the impacts on their financial markets and economies. The most vocal among them at the same time also criticised and mounted pressure on the Fed to pay heed to the impact of its policies on emerging markets. Since then the FRB seems to have become more mindful of this externality and more forthcoming and transparent in its announcements. It is perhaps in this spirit that the Fed now seems to be gradually building the case for tapering its ultra-loose monetary policy rather than announcing it abruptly.
The question is whether this now somewhat anticipated event will still impact emerging markets the way it did in 2013. What would be the exact repercussions for emerging markets when it eventually happens? Will India be impacted? What can it do ex ante or ex post to insulate itself or to mitigate the impact?
In my research with Barry Eichengreen (including ‘ Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets’) analysing the tapering event of 2013 and similar other emerging market sell-off episodes I have distilled the following lessons.
First what mattered the most in determining the impact of tapering across different countries was the size and depth of their financial markets. Investors seeking to rebalance their portfolios concentrated on emerging markets with relatively large and liquid financial systems because these were the markets where they could most easily sell without incurring losses and where there was the highest scope for portfolio rebalancing.
Second the impact of tapering was felt more by countries that had attracted large volumes of capital flows and allowed exchange rates to appreciate in prior years.
In contrast there is little evidence that countries with stronger macroeconomic fundamentals in the immediately preceding period experienced smaller impacts on their financial markets. There are two implications of these findings: one that completely open capital accounts can be a mixed blessing for this can accentuate the impacts of financial shocks emanating from outside. Two by virtue of being a large and liquid market India is likely to be impacted by the next tapering event.
More Juices From the Sluices
India had traditionally maintained a closed capital account. Following the 1991 balance of payment (BoP) crisis it adopted an incremental and calibrated approach to liberalising its capital account. Over time these incremental measures have cumulated and India is now considered an open and large emerging economy with a deep and liquid financial market rendering it vulnerable to capital flow reversals during the emerging market sell-off episodes.
How can India address the impacts of such events? India’s response to the 2013 sell-off included monetary policy tightening higher import duties on gold expansion of a swap line with the Bank of Japan a scheme to raise resources from the diaspora creation of a special facility to accommodate the demand for foreign exchange from oil-importing companies and reassuring communications from the RBI to the markets regarding India’s sound fundamentals.
Similar measures were then implemented in response to a subsequent 2018 sell-off episode and may be used in similar episodes in future as well. Nevertheless new capital control measures can backfire – as they did in 2013 – and ought to be avoided.
Besides India should continue to hold an appropriate level of reserves avoid excessive appreciation or volatility of the exchange rate through the use of reserves and macro-prudential policy and prepare banks and firms to handle greater exchange rate volatility. While such ex ante measures can help limit adverse impacts they still do not offer a guarantee against sell-offs.
Thus it will also pay if India were to change the capital flow mix toward FDI flows find ways to diversify the investor base toward investors with a longer-term view and strengthen the current account including by improving the competitiveness of exports. Eventually a complete insulation can only be ensured if India graduates from the emerging market asset class.