February 19, 2014
The Tapers Good for India
By Nitin Desai
For the past five years, the world economy has been heavily influenced by the policy of quantitative easing (QE) that the United States Federal Reserve launched in November 2008. It involved large purchases of long-dated securities, including mortgage-backed assets. It was a novel policy, as the usual instrument of stimulating the economy by lowering interest rates with open-market operations in short-term treasuries was not available - since interest rates were already close to zero. The Keynesian solution of fiscal stimulus was ruled out, since it would never have passed through the Congress because of Republican opposition. QE had another formidable advantage: it helped improve the quality of banks' balance sheets, thereby encouraging them to resume lending.
But the Fed's recourse to QE was not just a measure to stimulate the economy in a near-zero interest rate environment or to rebalance bank portfolios by relieving them of longer-dated and riskier assets. It was also a move to rebalance the global macroeconomy by forcing an appreciation of currencies like the Chinese yuan. QE has been interpreted as the economic equivalent of what military strategists call "attaque a l'outrance" - an assault without limits - to break down strong defences, say, of the sort that China has created with its huge reserves and capital controls to protect the competitiveness of its manufacturing. This is particularly true of the third round of QE, which was open-ended and had no cap on the Fed's holdings.
The battlefield analogy became more explicit when the Brazilian finance minister, Guido Mantega, announced in September 2010 that a currency war had broken out. Other finance ministers were more circumspect, but most saw this as a US-China power game. China, mindful of what happened to Japan after the Plaza Accord revaluation of the yen, understood it as that and criticised the US for not doing enough to correct the global imbalance. India, presumably unwilling to annoy either of the two protagonists, took a neutral stand and called for a balanced outcome - in other words, a negotiated peace with give and take on both sides.
The situation seems to have turned around with the announcement in June 2013 of the "taper", the gradual reduction in the amount of purchases by the Fed. Stock markets the world over reacted sharply and many emerging market currencies are experiencing a downward pressure. In some ways, this is a product of the market players' belief that their bonuses are safer if they are wrong together rather than if they take the chance to be right in isolation.
The taper does not mean quantitative tightening. The Fed continues to buy, although at a lower rate, and its holdings continue to increase. The Fed's actions in the US bond market remain expansionary as long as the level of its holdings of securities continues to increase. The quantitative tightening will start when the taper ends and the Fed starts reducing its holdings of securities.
The massive infusion of global liquidity since 2008 gave the Indian government the soft option of relying on foreign inflows to finance a current account deficit. The policy response was liberalisation of foreign direct investment (FDI). In February 2009, the Indian government announced changes that expanded the scope of automatic approvals of FDI. In September 2012, it liberalised investments in aviation and multi-brand retail. Later, in July 2013, shortly after the taper was announced, FDI limits in several sectors were enhanced. But FDI flows had started accelerating from 2006-07, well before the liberalisation was announced. The average inflow per year from 2006-07 to 2008-09 was around $15 billion, which increased marginally to around $18 billion from 2009-10 to 2012-13.
The big acceleration was in the more volatile foreign institutional investment flows. Leaving out the panic year of 2008-09, inflows from foreign institutional investors (FIIs), which had started accelerating after the policy changes of 2002 and 2004, rose from an annual average of $13 billion from 2003-04 to 2007-08 to $27 billion from 2009-10 to 2012-13. The inflows from non-resident Indians (NRIs) boomed much later and amounted to more than $25 billion in 2011-12 and 2012-13. These flows were driven less by policy changes in India and more by the liquidity pumped into the banking system in the US and the low interest rate regime there.
The taper, once completed, will alter this easy availability of FII and NRI money. The squeeze will get worse as the Fed runs down its holdings of securities as they mature. Already, since December 18, the top 30 Sensex stocks in terms of FII holdings fell by almost twice as much as the Sensex itself. With FIIs holding accounting for 23 per cent of the Sensex stocks, the stock market will be vulnerable to any monetary tightening in the US. But that is the price we pay for following the soft option of foreign capital inflows to finance our deficit instead of the harder option of correcting the fiscal deficit and the current account deficit.
The recourse to foreign capital inflows suppressed the adjustment of the exchange rate to differential inflation. Between 2003-04 and 2011-12 the exchange rate remained more or less stable around Rs 45 to a dollar - except in 2007-08, a boom year for foreign inflows. But the inflation differential between the US and India cumulated to around 40 per cent in this period, suggesting an exchange rate of Rs 60-63 to a dollar. Clearly, the rupee was getting overvalued, with deleterious effects on exports - thus pre-empting the rational option of correcting the current account deficit by reducing the trade gap.
QE gave a weak government an easy way out, allowing it to run large budget and current account deficits. The inflationary consequences were tackled with high interest rates, which also helped stimulate capital inflows - particularly as NRI deposits. But it had a disastrous effect on domestic investment and compromised long-term growth prospects. It was a singularly short-sighted and dangerous policy stance, though the recent interim Budget suggests that policy is moving in the right direction. But we still have a long way to go before we can get back to a more sustainable macroeconomic balance. That is why the taper is good for us. It will force the government to follow the more sensible path of correcting the twin deficits.