India was one of the hardest hit of the emerging markets after the US Federal Reserve first hinted it would cut back its quantitative easing program in May 2013. There were three reasons for this. First, global markets over-reacted. Second, India had many macroeconomic weaknesses. Third, since its capital markets were deep and liquid enough, they offered an avenue for portfolio managers targeting reduced exposure to emerging markets.
But since this blow, there have been corrections in all three areas. Therefore, the final withdrawal of US quantitative easing (QE), which the US Federal Reserve announced at the end of October, will not have a similar effect on the Indian economy.
Part of this is that, while the initial announcement took markets by surprise, they now factor in the withdrawal of QE and have adjusted their portfolios. This time around, the US Federal Reserve was more careful in signalling change and preparing markets. Markets did not over-react. Moreover, the European Central Bank and the Bank of Japan (BOJ) will continue to pump liquidity into world markets, which will allow for a more gradual market adjustment.
But, more importantly, the Indian economy is much stronger now than it was before talks of tapering. Inflation has fallen, growth has bottomed out, and the current account and fiscal deficit have reduced. Political stability and the new government’s focus on strengthening governance and relieving domestic bottlenecks improve India’s future prospects.
And while markets remain open and liquid, foreign investment in Indian debt markets, which will be the most affected, is capped in India. Over the last year, India did raise the ceiling for investment in Indian debt. But equity flows still dominate and they normally distinguish between emerging markets. Among the BRICS, India is poised to benefit most from the softening commodity prices.
This fall in commodity prices is likely to continue. QE, which consciously sought to drive up asset prices, also drove up oil prices. But that rise brought about a permanent rise in supply and weakened OPEC’s power to fix prices. Chinese demand has also slowed, but that is not the primary reason for the fall. The year 2012 saw the first steep fall in Chinese growth to 7.7 per cent from 9.3 per cent the previous year, but oil prices did not soften.
India introduced a range of measures after the tapering talk in 2013. Indian policymakers can use that experience to select short-term measures to brace against any impact of the US Federal Reserve ending its QE program.
The measures clearly demonstrated the effectiveness of building up reserves and using them in targeted intervention. A prime benefit of equity inflows is that they are risk sharing. General intervention would reduce this, as it would give a better currency value to departing short-term capital. Moreover, it may make too much of a draft on reserves. Oil swaps, however, proved effective in taking concentrated dollar demand from domestic oil-importing firms off the market. This smoothed the volatile dollar demand.
Defending the rupee with interest rate changes and market restrictions proved to be less useful.
In addition to improving longer-term economic fundamentals, Indian policymakers acted on these lessons. They built up reserves augmented by a swap line with the BOJ. There is regular intervention to reduce rupee volatility, while the real effective exchange rate has not been allowed to appreciate too much in the face of large inflows.
One negative is that larger Indian interest differentials have attracted more investment into Indian debt over the last year. Differentials were high because policy was in inflation fighting mode. The saving grace is that the debt inflows continue to be capped.
Another consequence of higher domestic interest rates, especially since the rupee has stabilised, is firms have been borrowing abroad at lower rates without hedging their exposure... Again, these borrowings are capped.
If outflows come following the QE withdrawal, the Reserve Bank of India is well set to respond with a combination of measures including moderately depreciating the rupee. But they should not raise interest rates or re-impose market restrictions that are being gradually lifted.
India is better equipped to weather the end of quantitative easing now than it was back in May 2013. Indian policymakers should look to the past to be ready for a future without quantitative easing.