Time for policy orthodoxy in India
With global dark clouds still on the horizon, India should steer clear of domestic policy adventurism
Emerging markets (EMs) have had a rough ride since April this year. A combination of higher US rates, a stronger dollar and rising oil prices has culminated in a perfect storm with repricing of EM risk premium. Portfolio outflows have resulted in weaker currencies and higher domestic bond yields in a number of countries. Countries with twin fiscal and current account deficits have suffered more. Argentina has suffered from a crisis of confidence and has approached the International Monetary Fund (IMF) for a lifeline. Turkey—another twin-deficit country—has been hit as investors have questioned the independence of the central bank; it hiked rates by 300 basis points last week. Bank Indonesia hiked rates in mid-May for financial stability reasons and has called for an unscheduled board meeting this week, where it is widely seen delivering another 25 basis points pre-emptive hike. There are some fears of contagion within EMs.
India is no exception. Given its twin deficit and oil dependence, the Indian rupee has been the worst-performing Asian currency so far in 2018 and domestic bond yields have inched higher. Forthcoming elections have added to fears that political priorities may result in fiscal slippage in 2018-19. In the last few days, the fall in oil prices and lower US rates have infused risk appetite back into EMs. However, whether rising EM risk premium is transitory or the start of a major unwind is hard to say at this stage. A number of potential events could trigger a repricing of the risk premium in the coming quarters, including global quantitative tightening, rising protectionism or a China-led slowdown.
The IMF “Global Financial Stability Report” estimates that US balance sheet normalization and higher Fed funds rate, if accompanied by risk aversion, could reduce portfolio inflows into EMs by an average of $60 billion in 2018-19, or 25% of annual inflows from 2010-17. The resultant tightening of global financial conditions could trigger balance of payment risks or aggravate credit risks in EMs. There is only one strategy to follow in such times: Hope for the best, but prepare for the worst.
India, thankfully, has been on a correction course since 2014, as a result of the move towards flexible inflation targeting and a positive real rate regime. Prudent monetary and fiscal policies place India’s macro fundamentals on much higher ground today than in 2013. Yet, given the global backdrop and risk that quantitative tightening could spring a surprise anytime in the coming quarters, there is no room for complacency. India should stand ready with a multi-pronged strategy.
First, this is no time for fiscal adventurism. Fiscal balance is India’s Achilles heel and the medium-term fiscal deficit target of 3% of GDP has already been pushed out a number of times. Yes, political priorities may be different in a pre-election year, but it would be prudent to instil confidence among investors that the fiscal deficit targets will be strictly adhered to. India could take a leaf out of Indonesia’s playbook, where the authorities have focused on improving the fiscal-monetary mix to ensure financial stability. While Bank Indonesia is pre-emptive, the government has also affirmed its commitment to the fiscal deficit targets.
Second, India does not need an interest rate defence of the currency for many reasons: It attracts more equity flows than debt flows; it is not an open economy, so domestic interest rates matter more than exchange rate; and domestic balance sheets are still fragile and could deteriorate sharply if interest rates rise too sharply.
Nevertheless, monetary policy should stand ready to reinforce inflation credibility, as studies have found that high-inflation countries are more susceptible to capital outflows. If financing the current account deficit remains a challenge, as has been the case since mid-April, then higher rates may be necessary. Of course, the challenge would be to balance external risks against a weak domestic balance sheet.
Third, balance of payment funding pressure doesn’t yet warrant a 2013-style resource mobilization. However, if funding pressures aggravate, then a confidence-building measure such as issuance of a non-resident Indian bond—à la resurgent India bonds or India millennium deposits—could be used to garner additional dollars to plug the balance of payment deficit.
It is true that India has adequate foreign exchange reserves that can be used to smooth volatility, but defending a particular level on the currency is a losing proposition; a sustained decline in foreign exchange reserves can itself shake investor confidence and trigger even more capital outflows.
Finally, investors expect reforms to take a back seat this year as the focus shifts to elections. Given low expectations, policymakers could surprise investors positively by pushing ahead with banking reforms, sticking to subsidy reforms, reducing market borrowing, or doing whatever it takes to lower the India risk premium.
Some may argue that the route to orthodoxy will lead to slower growth, but this is only in the short term; growth will be more stable in the medium term. The other option—allowing imbalances to fester—will lead to slower growth and a bigger price to pay in the medium term as risk premium will rise sharply.
Easy global monetary policies since the 2008 financial crisis have led to some EMs partying hard. This party may now be coming to an end. It is time for India to sober up.
Sonal Varma is managing director and chief India economist, Nomura.
Comments are welcome at firstname.lastname@example.org.