International Finance term paper
Indian economy in general and stock markets in particular are believed to be the bearers of the brunt of tapering in quantitative easing. This tapering is haunting stock markets in India since past few months. Even the Finance Minister had stated that stock markets in India were hit by global factors and reiterated that fundamentals of Indian economy have not changed at all to cause this volatility. While the statement given by the Finance Minister sounds political as domestic factors have pulled market down, the role of tapering cannot be ignored completely. In May'13, Ben Bernanke announced that Federal Reserve is thinking of 'tapering' of some of its QE measures stating that it would scale back its bond purchases. This news was badly received by the stock markets across the world and sent Indian markets into panic. US bond yield went up and US investment companies started withdrawing from India. What caused more worry in the international markets was that Ben Bernanke suggested that the bond buying program could wrap up by mid-2014. While Ben Bernanke did not announce an interest rate hike, he hinted that if inflation follows a 2% target rate and unemployment decreases to 6.5% then Fed would likely start raising rates. All this news has worked negatively for Indian markets as well as many emerging markets. Now when the announcement of actual tapering starting from Jan'14 has been made it will be interesting to see how the scenario unfolds itself. The paper therefore first tries to study the impact of Federal Reserve's QE program and then analyses possible impact of QE tapering on Indian economy.
The measures to kick start the engine of growth, by enticing the investors and consumers by keeping zero rate of interest, had failed to stimulate the developed economies. They therefore resorted to large-scale asset purchases by their central banks, such as corporate bonds or mortgage backed securities, to pump more money into the banking system. The aim was to extend credit to businesses and industry and encourage consumption. In US along with keeping the long term interest rate subdued the Federal Reserve had announced a securities and treasury buying programme starting from the recession period of 2008-09. Till now, through the successive enhancement of its bond buying programmes known as QE1, QE2, and QE3 Fed has committed to inject $85 billion of money every month. This Quantitative Easing (QE), designed to pep up the U.S. economy after the financial crisis of 2008-09, has survived for more than five years. But as the capital barriers are being lowered in the globalizing world, the flood of money released through bond buying programme has found opportunities elsewhere which provide higher rate of return. Countries who need the capital to fund its own growth, welcomed this capital. India has been a significant beneficiary of this capital outflow from US. Large capital inflows into India can be sourced to monetary easing in the developed world. In 2012, India received as much as $88 billion of capital inflows, and around $31 billion of money only after QE3 despite deteriorating macroeconomic conditions, and also weak corporate fundamentals, quite largely attributable to global monetary easing.
In the developed economies since interest rates remained at zero and the growth remained stagnant, it was inevitable that there would be significant capital outflow to emerging and other developing economies, in quest of higher risk-adjusted returns. This massive and continuing surge of capital outflows had a major impact on emerging and other developing economies. Corporations having sound credit rating were taking on more debt and increasing their foreign exchange exposure as they were attracted by low borrowing costs. As a result of which their vulnerability to future interest rate changes in the developed world and exchange rate volatility were increasing. Such inflows into the emerging economies put upward pressure on exchange rates thus providing incentive for imports and further affecting their already suffering current account deficit. It also stimulated credit expansion and caused inflationary pressures which posed a major challenge to policy-makers in the developing world. Most of the capital inflows were in the form of portfolio investments, which are susceptible to sudden and volatile movement and thus put emerging economies at greater risk.
Need to study impact of tapering in QE
In general, the overall impact of the capital inflows is expansionary and distortionary. The magnitude of QE has had unintended consequences beyond the borders of G4 countries, especially because their currencies are not only fully convertible but, together they constitute the pillars of the global financial system. The U.S. dollar is the world's reserve currency & the euro the British pound and the Japanese yen together constitutes the basket of currencies that the International Monetary Fund (IMF) uses to value member countries Special Drawing Rights. Thus, the nature of the currencies and their significant role in the global financial market ensures that QE undertaken by them has a global impact on economies across the globalised and interconnected world. It therefore becomes necessary for the G4 to act with greater responsibility and to engage the emerging economies to minimise the adverse effects of their QE policies. It is particularly important to forge a consensus on how to handle the potential financial turmoil and disruption that may afflict developing economies as the QE is sought to be retired and interest rates once again become positive in the US, the key contributor amongst G4 to global liquidity. The sudden and large-scale reversal of capital flows therefore needs to be managed properly and the emerging countries need to prepare themselves for this situation.
Looking at impact of announcement in tapering of QE's:
It's generally believed that emerging markets have fared badly since May'13 when Ben Bernanke hinted that the Fed would soon move to scale back QE, from the current purchases of $85 billion per month. After this announcement between April and September 2013, India's currency, depreciated by an alarming 17%. But India was an exception; the majority of emerging market currencies saw appreciations over the period. That could be because markets interpreted tapering signalled an improvement in American economic fortunes which can only be good for global trade.
Amongst the emerging markets, the richer emerging markets tended to perform badly when compared to other emerging markets. This is because they had relatively deep financial markets so investors were more likely to hold on to their existing assets. Also Global financiers seeking to rebalance their portfolios actually had money in these economies which they were thinking of withdrawing.
On the other hand, economies that did better tended to be those with more credible fiscal and monetary policy. Chile's inflation tended to remain below target; Malaysia ran a healthy current account surplus. These economies reaped gains since May'13. The exchange-rate changes for eight emerging markets as well as their current-account balances, through the beginning of 2014 have been shown below.
Volatility is generally high around the period when major central banks consider ending stimulus measures, but there is one key difference between the quantitative easing this time as compared to past situations. The difference is that the program was open-ended i.e. the schedule for withdrawal was a matter of judgment and discretion. By extension, this has amplified volatility in financial markets. In India's case, examination of select macro-indicators and their trends around the previous quantitative easing periods provide notable insights. Firstly, the key unfavourable domestic development during QE3 as against QE1 & QE2 was that even as the fiscal picture had improved, the growth outlook deterio??rated markedly and current account shortfall ballooned. As a result of the latter, reliance on debt-creating foreign capital flows has grown significantly. Therefore since speculation on QE3 taper??ing has surfaced in May'13, foreign capital outflows topped $4 billion from the equity and debt markets and saw rupee tumble to record low.
Source: RBI database on Indian economy
Source: RBI database on Indian economy
Secondly, two of the three US Fed QEs have been accompanied by stimulus packages by Indian Govt. along with reforms. This has served to magnify the gains in the lo??cal financial markets. In the early months since QE1 was announced in depths of US financial crisis, the Indian government unveiled multiple stimulus pack??ages, along with sharp cuts in the policy rate by the central bank. This led GDP growth higher from 6.0% in FY08/09 to 11.8% in 09/10, with the domestic federal elections also providing the much-needed stimuli.
Source: RBI database on Indian economy
Analysis of likely impact of tapering on India:
Even as the reaction to the scaling back of US asset purchases has been adverse, two important factors need to be considered a) tapering will be a drawn-out process, i.e. not turning off the tap all at once, and b) the scaling back will not nec??essarily be in a straight line and could be scaled-up or down if economic condi??tions deteriorate. Nonetheless, factoring in a prolonged period of volatility in the financial mar??kets over the QE3 withdrawal, the impact on India could be multi-fold. In the immediate term the currency could remain under pressure which will indirectly have an impact on inflation, financial stability, fiscal outlook and trade balances. Secondly the room for monetary easing narrows further as US bond yields rise and currency remains weak. Importantly, strong capital inflows that had balanced out the record high current account deficit appear to be thinning out, raising concerns over the balance of payments position.
A) Risks of rate cuts being pushed out
After the RBI belatedly jumped into the rate-cutting bandwagon, risks that the cycle has run its course are becoming more apparent. Admittedly, the RBI's cautious approach to monetary easing is partly to blame, but the rise in US bond yields and weak currency had already lowered the possibility of a July rate cut and the same was observed in the monetary policy. The room for monetary easing had narrowed when the economy needed it the most. The timing is however contingent on the rupee momentum and stabilisation in the capital flows. If rupee depreciation continues, the cut envision would get delayed.
B) Risk of currency depreciation
Apart from the dollar-led weakness in the rupee exchange rate, domestic soft-spots have also fuelled the bear-run in the currency. On real effective exchange rate basis (REER), the improving inflation outlook has seen the rupee recover from lows (as of latest available May13). The graph shows INR REER remains above the 10-year average, though on nominal effective exchange rate (NEER) basis the currency has lost substantial ground even before the depre??ciation streak in Jun'13. While the latter serves as a gauge of trade competi??tiveness, in absence of material pick-up in demand amongst the key trading partners, the weak currency will be of little help to the exporting community.
Instead, prolonged rupee depreciation carries other risks. It could de-rail the easing WPI inflation trajectory, by overwhelming benefits from lower international prices through the tradable component. As a result the scale of adjustments needed in retail fuel prices to match market rates might also rise. To put things in perspective, 10% depreciation in the rupee against the dollar adds 60bps to the headline WPI inflation in the short-run and 120bps longer-out. At present record low currency levels, there is a risk that 80-100bps could be added to the end-year WPI estimate.
A weak rupee also offsets the potential improvement in the trade balances from lower commodity prices, alongside heightening currency risks for offshore borrowers. The tight onshore liquidity conditions and high borrowing costs had prompted the authorities to loosen regulations on external commercial borrowings (ECBs). While corporate actively tapped this source of funding, the pitfalls cannot be ignored. In view of the recent rupee tumble, currency risks have potentially eroded any benefits from lower offshore borrowing costs. In addition, borrowers with substantial unhedged exposure are likely to be the worst hit, an aspect that the RBI has highlighted in recent months. For instance, more than $8 billion average ECBs were raised by institutions when the bilateral rupee exchange rate was below 50.0, which if pegged to present market rates, will translate into sizeable losses.
C) Risk of Financing and BOP crises
The four-fold increase in portfolio inflows since QE3 and domestic reforms in Sep'12 successfully muffled the stark current account deterioration, especially the climb to record -6.7% of GDP in Oct-Dec12 quarter. The improvement in the Jan'13-Mar'13 to -3.6% while positive is likely to be short-lived. What caused that current account to balloon in the first place was the usual drag from a weak merchandise trade balance, on higher gold and energy imports. In addition, investment income outflows also hastened in the quarter, which includes inter??est paid to non-resident deposits and reinvested earnings of FDI companies, amongst others. While the falling commodity prices could benefit the trade balance, there are still signs of weakness in the other sub-components of the current account. Before the recent shake-out, financing the CAD was not expected to be a prob??lem given strong portfolio inflows, non-resident inflows and external commer??cial borrowings. However, assuming a prolonged period of investors' portfolio readjustment, the focus could shift from an inflated CAD to financing fears and eventually a potential balance of payments crisis at hand. As such we ex??pect the CAD to hold-up at 4.5% of GDP in 13/14, down from record 4.8% in 12/13. The feedback mechanism will only delve more downside pressure on the national currency. A revisit of the 1991 BOP crisis however, is distant especially as the foreign exchange reserves stock is sizeable by historical standards. The imports cover whilst on the decline is far from alarming levels. A more market-oriented exchange rate and contained global commodity prices also help put worries to rest.
D) Impact on Indian businesses
Easy money overseas means that Indian companies could resort to borrowing more overseas. According to the latest RBI monthly data for August 2012, Indian companies sought permission to borrow to the tune of $2.4bn. Borrowing overseas is good if interest rates are low but with the Indian rupee remaining volatile, companies could get hurt due to currency losses. If the rupee remains stable, the overall borrowing cost of companies could fall. However, if it falls further, companies may have to pay more.
E) Some Positives of QE unwinding
There could be some positives over the medium term because of QE unwinding. With global commodity prices likely to soften further on the back of QE unwinding, India's trade balance is likely to improve since it is a large importer of global commodities. In addition, over the next few quarters rupee depreciation of the magnitude that we have seen over the last few months would lead to a natural correction of our trade imbalance with a pick-up in exports and drop in imports, especially if the increased import prices of commodities such as oil are passed on to consumers. The government would do well to urgently address issues that can bring back some confidence in the Indian economy, issues such as getting the mining ban lifted, ensuring an adequate flow of raw materials to industry - coal, iron ore, sand, natural gas etc. - push through approvals for stalled projects, facilitate land acquisition for large projects, clear overdue receivables due to vendors from the government and its agencies and provide regulatory clarity in several sectors like telecom, electricity, oil & gas etc. All these will put pressure on Govt. to address the issue of current account imbalances and maintain the reform momentum. This might aggravate downside pressure on the rupee, but help narrow the case for ex??cessive monetary easing, in the light of the adverse macro imbalances and high retail inflation.
F) Change in intensity of impact because of elections
As we close-in on general elections by May'14, the reforms' schedule is likely to remain reactive for the next twelve months rather than being proactive. Moreover the willingness to introduce reforms will also be hamstrung by political road??blocks, with much effort being focused on populist and flagship schemes like the food security bill. So risks from rating downgrade and reversal in the fiscal consolidation stance are the two main themes that will have to be monitored.
In the short-run, efforts will be on to contain stark and rapid rupee deprecia??tion, to prevent risks to financial stability. The limited foreign reserves arsenal will make the central bank maintain minimal and intermittent presence, along??side frequent jawboning efforts. Other interim measures that can be consid??ered include enforcing of staggered dollar purchases by importers, conduct special market operations by way of providing dollar liquidity directly to oil companies and increasing FII limits in debt investments. On the FII debt limits, in particular, the potential to increase in the foreign par??ticipation in the local debt market is substantial, though that cuts both ways. The flotation of an offshore NRI bond is also a suitable option, with ideal proceeds of USD 15-20bn sufficient to beef-up the reserves stock and also provide assurance of sufficient funding.
The US Fed's decision to claw back the asset purchases is based on the judgement that growth indicators are looking stable. Alongside, risks of a possible surge in inflation are also low. Therefore beyond the present volatility, an improved global growth and inflation outlook will instead prove beneficial to most asset classes and economic activity.
The taper is not such a bad news as it was when it was first talked off as the market is lot better prepared. India has had very successful FCNR (B) scheme bringing in dollar. Also it has had FIIs reduce their positions dramatically so there is very little hot money to go out right now. In general, current account deficit, export numbers are also looking a lot better. So to that extent the market is a lot better prepared which is why the reaction in the markets across all emerging markets and of course for India seems a lot more muted then it was in May or June of 2013.
' Reserve Bank of India (2008) 'Macroeconomic and Monetary Developments in 2008-09', Mumbai, April 20, 2009.
' Reserve Bank of India 'Handbook of Monetary Statistics of India', Mumbai
' Reserve Bank of India (2008) 'Handbook of Statistics on the Indian Economy', Mumbai
' Statistics on Economy of ECB, BoE, Federal Reserve
' Eichengreen, Barry, and Poonam Gupta. 2013. Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets. World Bank Working Paper. Washington: World Bank.
' Asian development bank Working paper series  on ' Impact of US Quantitative easing policy on Emerging Asia'
' Truman, Edwin M. 2013. 'Enhancing the global financial safety net through central-bank cooperation,' Vox-EU Column, September 10.
' DTZ insight report on Quantitative easing
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