View: why, despite the impact of tapering, India does not have to worry too much about the Fed’s decision
While nearly 30 countries were affected 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 9%, while stock prices fell 5%. Foreign exchange reserves fell by 7% and the average bond yield rose by more than 50 basis points (bps) in the fragile five.
The largest exchange rate depreciation occurred in Brazil, the largest decline in stock prices in Turkey, and the largest loss of reserves in Indonesia. India recorded the second largest exchange rate depreciation (almost 16%) and the second largest decline in reserves (around 6%).
Central bankers have struggled to contain the impacts on their financial markets and economies. The most vocal of them have also criticized and pressured the Fed to heed the impact of its policies on emerging markets. Since then, the FRB seems to have become more attentive to this externality, more open and more transparent in its announcements. It is perhaps in this spirit that the Fed now seems to be gradually building the arguments in favor of reducing its ultra-accommodative monetary policy, rather than announcing it abruptly.
The question is whether this now somewhat anticipated event will still have an impact on emerging markets as it did in 2013. What would be the exact implications for emerging markets when it does happen? Will India be impacted? What can it do ex ante or ex post to isolate 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”) analyzing the 2013 tapering event and other similar episodes of emerging market liquidation, I have distilled the following lessons.
First, what mattered most in determining the impact of tapering in different countries was the size and depth of their financial markets. Investors looking to rebalance their portfolios focused on emerging markets with relatively large and liquid financial systems, as these were the markets in which they could most easily sell without incurring losses and where there was the greatest portfolio rebalancing margin.
Second, the impact of tapering was felt more by countries that had attracted large capital flows and allowed exchange rates to appreciate in previous years.
In contrast, there is little evidence that countries with stronger macroeconomic fundamentals in the previous period experienced weaker impacts on their financial markets. There are two implications of these results: first, that fully open capital accounts can be a mixed blessing, as it can exacerbate the impacts of external financial shocks. Second, due to the fact that it is a large and liquid market, India is likely to be affected by the next downturn event.
No more juice from the locks
India had traditionally maintained a closed capital account. Following the balance of payments (BoP) crisis of 1991, it adopted a gradual and calibrated approach to liberalize its capital account. Over time, these incremental measures have accumulated and India is now considered a large, open emerging economy with a deep and liquid financial market, making it vulnerable to capital flow reversals during episodes of market liquidation. emerging.
How can India cope with the impacts of such events? India’s response to the 2013 liquidation included tightening monetary policy, higher import duties on gold, expanding a swap line with the Bank of Japan, a program to mobilizing resources from the diaspora, creating a special facility to meet demand for foreign exchange exchanges from oil importing companies and reassuring communications from the RBI to markets on India’s good fundamentals.
Similar measures were then implemented in response to a subsequent liquidation episode in 2018 and could also be used in similar episodes in the future. However, further capital controls can backfire – as in 2013 – and should be avoided.
In addition, India should continue to hold an appropriate level of reserves, avoid excessive exchange rate appreciation or volatility through the use of reserves and macroprudential policy, and prepare banks and businesses to manage a crisis. greater volatility of exchange rates. While these ex ante measures may help limit negative impacts, they still do not offer a guarantee against mass sales.
Thus, it will also pay off for India to shift the composition of capital flows in favor of FDI flows, find ways to diversify the investor base to longer term investors, and strengthen the current account, especially by improving the competitiveness of exports. Ultimately, complete isolation can only be achieved if India steps out of the emerging market asset class.