#dnaEdit: Taper tantrums

In her recent speech at the Reserve Bank of India, Christine Lagarde, managing director of the International Monetary Fund (IMF) — rather piquantly — brought out the current dilemma in the global economy. She referred to the “taper tantrums” and their effect on the fortunes of the global economy — and more particularly — on the emerging and developing markets.

There is increasing talk in the US about unwinding the special monetary stimulus and bringing the US policy back to normalcy. Here’s some context to the present discourse: to stave off a Great Depression kind of moment in the wake of the 2008 financial meltdown, the US had introduced unprecedented expansion of liquidity in its financial system. Interest rates, which were slashed to near-zero, currently stands between 0 and 0.25%. Now that the US economy is growing and unemployment has whittled down to what is known as “full employment levels” — that is around 5.5% of overall employment — there is renewed talk of an interest rate hike. 

A hike in interest rates would mean that funds that had moved out of the US would flow back into the country. According to estimates — since 2008 — nearly $4.5 trillion of funds have come into the emerging market economies.

India received $470 billion of these fund flows in the form of FII investments. 

Talk of resetting the US monetary policy to normal levels first began in May 2013, immediately touching off a chain reaction that resulted in large amounts of funds moving out from the emerging market economies. Between May and November that year, financial markets in the emerging market economies swung wildly while currencies fluctuated. This volatility posed serious economic and financial challenges in the countries affected by it. Current talks of revamping the US monetary policy have the potential of triggering yet another round of volatility in financial markets as well as in currency exchange rates: the volatility Lagarde describes as ‘taper tantrum’. 

How far is India vulnerable to such a revamped US monetary policy? Any major disruption in capital flows would surely have some impact on India’s financial and economic sectors. But for the time being such apprehensions are tempered due to several factors. 

First, in her public statement on Wednesday, the US Federal Reserve chairperson, Janet Yellen, ruled out a tightening of monetary policy — at least till April. Yellen was uncertain whether a rate hike would come into effect even in July. The markets are interpreting this to mean that the changed policy may come into operation only towards the latter half of the year. 

Second, apart from a rate hike, Yellen’s indications are that the pace of the hike could also be moderated. That is, even if there is a hike or hikes, they would come in small doses. That’s good cheer for everybody concerned, besides allaying the nervousness in financial markets. The latter are now more hopeful of Fed guidance being in line with their expectations. 

Third, as for India, the country is in a much better situation to handle any possible volatility than before. Its vulnerability to capital movements is now less because of the manageable current account situation. The deficit on current account stands at a negligible 1.9% of GDP, as opposed to 4.7% in May 2013, when the buzz about US tapering started. In absolute terms, the current account deficit of $88 billion in 2013 now stands at just about $18 billion. This means even in case of withdrawal of capital inflows, the impact is not likely to be devastating. 

At the end, handling volatility in the global market would be far easier now than three years ago. In addition, the somewhat higher current foreign exchange reserves would also help in neutralising the volatility. But, Christine Lagarde’s caution about possible economic headwinds is timely. It is no doubt better to be prepared that to be taken by surprise in an uncertain global economy.