In its latest monetary policy statement the US Federal Reserve has indicated that a moderation in the pace of asset purchases may soon be warranted.
As part of its response to the Covid pandemic, the Fed has been buying $120 billion worth of securities every month to maintain accommodative financial conditions in order to support the flow of credit to households and businesses.
Its Federal Open Market Committee (FOMC) has the mandate to achieve maximum employment and inflation at the rate of 2 per cent over the long term.
In its meeting this week the FOMC noted that the economy has made progress on these goals and if the progress continues, a moderation in the pace of bond buying may soon be announced.
Unlike the taper tantrum episode of 2013, the Fed has been signalling a discussion of slowing bond purchases for a few months now. India should continue to focus on improving its macro-fundamentals and avoid drastic policy responses to limit the possible spillovers from the tapering of bond purchases.
While the US Fed is not mandated to consider the potential spillover impact of its actions, the Fed has been more sensitive this time and has so far managed to prevent jitters in global financial markets. The world now understands that when the Fed says it will taper, it does not take drastic action immediately.
What happened in 2013
In May 2013, the then Fed Chair Ben Bernanke, in his testimony to the Congress suggested that the FOMC might soon start to slow down its bond purchases. In response to this statement, the US 10-year bond yield surged and triggered a wave of capital flight from emerging economies.
The most affected countries from the “taper tantrum” were South Africa, Brazil, India, Indonesia and Turkey — dubbed the “fragile five” by Morgan Stanley due to their high current account deficits and dependence on inflows of foreign capital.
In India, these capital outflows put pressure on the rupee. The Reserve Bank of India (RBI) believed that the outflow from India was not in line with fundamentals of the Indian economy, and was temporary, caused mainly by an exogenous shock.
In response the Government of India and the RBI launched a defence to reduce the pressure on the rupee. These included a combination of monetary policy tightening through raising short-term rates, restrictions on gold imports, capital controls on outflows, easing of controls on foreign currency borrowings and borrowings from NRIs.
These measures were implemented through June, July and August, 2013 to arrest the rupee depreciation.
However, the rupee fell by over 15 per cent between late May and the end of August. Notably, the depreciation of the rupee was sharper than those of other emerging markets, which hadn’t undertaken such a large number of bans and capital controls or tightened liquidity in domestic markets.
Today India is in a better position than in 2013. The current account is in far better shape, with India reporting a surplus last year.
But it still has pain points: higher inflation and a large fiscal deficit. As economic activity gains momentum, these concerns need to be addressed to mitigate the possible impact of the tapering of bond purchases.
While inflation is transient, driven by supply side bottlenecks, as demand picks up, inflationary expectations would need to be anchored effectively.
In recent years, the government and the RBI have taken a number of steps to facilitate foreign investments in Indian bonds.
Last year, the RBI opened certain specified categories of government securities for unrestricted access to foreign investors. While foreign investments in government debt is restricted to 6 per cent of outstanding stock, this limit does not apply to some notified bonds.
This move is a first step towards facilitating inclusion of rupee bonds in global bond benchmarks. Foreign funds are increasing exposure to Indian debt amid expectations of inclusion of the country’s bonds into global indices.
India needs to continue such conducive policies to reduce its vulnerability to sudden outflows of capital. Less friction for foreigners who invest in Indian assets should be part of the policy response.
As against $275 billion in forex reserves in August 2013, India’s forex currently stands at more than $640 billion. However, interestingly this has more signalling value than an instrument that is actually used.
In a recent research paper titled Analysing India’s Exchange Rate Regime, economist Rajeshwari Sengupta and myself showed that the RBI intervenes in the foreign exchange market in an asymmetric manner: its intervention is successful in preventing rupee appreciation but it does not intervene to prevent rupee depreciation.
In 2013, the RBI tried to prevent rupee depreciation not through intervention but through monetary policy tightening and capital controls. The knee-jerk reactions were largely ineffective and made the depreciation sharper. They distorted markets and created panic.
The way forward, thus, is to focus on fundamentals and ensure macroeconomic stability and avoid any kind of short term knee-jerk response in case we see a spillover from the taper talk.
Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.
Radhika Pandey is a consultant at NIPFP.
Views are personal.