With a better economic recovery and higher than expected inflation in the United States, the Federal Reserve has signaled that it may reduce its bond purchases. The International Monetary Fund (IMF), in its April 2021 World Economic Outlook, raised the possibility of capital outflows from emerging markets and developing economies (EMDEs) in the event of a turnaround in the financial cycle, causing a instability ahead for them.
EMDEs have long been exposed to surges and sudden stops in capital flows that occasionally undermine their macroeconomic stability and economic growth. The sources of such exposure are both internal and external. The external source has to do with the fallout from global financial cycles. The Fed’s monetary policy is a major determinant of these cycles, since the US dollar is effectively the world’s reserve currency. The easing of the Fed tends to whet the appetite for risk, sending a surge of capital to EMDEs in search of a higher return. Conversely, the tightening increases bond yields, pushing capital back to the United States. The internal policies of EMDEs can also lead to surges and abrupt stops in some countries, regardless of the global financial cycle. Lax capital controls can lead to huge capital inflows, leading to unsustainable external debt and / or an exchange rate appreciation that worsens the current account. Worsening macroeconomic imbalances, combined with triggers such as rising oil prices, defaults on external debt, a turnaround in the financial cycle, etc., can lead to a sudden loss of international confidence (and capital inflows).
The orthodox policy advice for EMDEs to avoid the build-up of macroeconomic imbalances is to choose between a combination of unrestrained capital flows and a flexible exchange rate on the one hand, or a fixed exchange rate with capital controls on the other. go. The underlying trilemma for EMDEs is that they cannot simultaneously support an “impossible trinity” of monetary policy independence, free capital flows and a fixed exchange rate. He must choose two out of three.
While a policy option derived from the Impossible Trinity Rule might work under normal circumstances, as Professor Helene Rey of the London Business School has pointed out, it might not be enough to deal with the fallout from changes in the financial cycle. when there is a blind movement of capital. in a sense. In such circumstances, EMDEs may have little choice but to throw sand in the wheels of such flows through some form of capital controls and macroprudential policies. The IMF has long since abandoned its policy advice to emerging markets in favor of fully liberalized capital accounts.
Unlike the global financial crisis, EMDEs have not weathered the covid economic storm as well as advanced economies (AEs). Nonetheless, with higher growth, international reserves, lower external debt, more robust inflation and current accounts, Asian EMDEs are better equipped to weather an interest rate pivot in the United States. Two-thirds of the increase in international EMDE reserves since 2001 has been in Asia. The EMDE’s Asian external debt, at 20% of gross domestic product (GDP), is well below the EMDE’s average of 31.5%, and its current account is projected at three times the EMDE average. EMDE. In 2020, EMDEs in Asia were halved compared to EMDEs in general, and their average inflation by 3% is 200 basis points lower than the average EMDEs.
However, some countries will be more vulnerable than others, regardless of their geography. Past experience, especially during the crisis crises of 2013, when the Fed was widely expected to reduce its quantitative easing (QE), indicates that EMDEs with weaker macroeconomic fundamentals are hit harder. In 2013, India was among the hardest hit countries because its current account, budget deficits and inflation were well above the EMDE average. India was among the “fragile 5”, the other four being Brazil, South Africa, Turkey and Indonesia, with the Indian rupee falling by around 25%.
To what extent is India today exposed to a possible taper tantrum, compared to 2013? At 20% of GDP, India’s external debt is eminently sustainable. Its burgeoning foreign exchange reserves also provide an adequate cushion as measured by the Greenspan-Guidotti rule (reserves minus short-term external debt). But both were also quite comfortable in 2013.
The table above shows that with the exception of the current account deficit, all the parameters that made India vulnerable in 2013 are again significantly above the EMDE average. India is the only country among eight major emerging markets that presents four of the five selected macroeconomic parameters much worse than average. Brazil, South Africa and Turkey have two misaligned, while Bangladesh and Thailand have one each. India’s nominal current account deficit also does not inspire confidence, as both exports and imports have fallen sharply. It could get worse if oil prices go up.
Additionally, there are five additional vulnerabilities that were not highlighted in 2013. First, there is the ongoing deadly second wave of covid, with the epicenter of the pandemic appearing to have shifted to India and the United States. uncertainties about the adequacy of its immunization program. Second, India’s disproportionate decline in growth relative to EMDEs, with the economy contracting by 8% in real terms in 2020-2021. The Indian economy has now returned, in real terms, to where it was in 2017-18. This is in addition to the periodic declines in year-over-year growth between 2016 and 2017. Third, there are strong headwinds on the path to economic recovery due to the deterioration of India’s banking system. Fourth, both exports and private investment show a long-term downward trend. Fifth, even as India’s budget deficit is above the EMDE average, there are headwinds against the fiscal correction as its tax-to-GDP ratio tends to decline, indicating a tax system failing.
For all these reasons, India is particularly vulnerable to the external shock of a rise in US interest rates and a turnaround in the global financial cycle. The country’s macroeconomic fundamentals do not look good compared to its EMDE peers. It is also much more exposed than the rest of the Asian EMDEs. India would do well to be careful.
Alok Sheel is RBI Professor of Macroeconomics, Indian Council for International Economic Relations Research
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