India must watch out for a taper tantrum in global capital markets

EMDEs have long been exposed to sudden surges and stops in capital flows that injure their macro-economic stability and economic growth from time to time. The sources of such exposure are both internal and external. The external source has to do with spillovers from global financial cycles. The Fed’s monetary policy is a major determinant of these cycles, since the US dollar is effectively the global reserve currency. Fed easing tends to whet risk appetite, sending a surge of capital to EMDEs in search of higher yield. Conversely, tightening raises bond yields, sucking capital back to the US. Internal policies of EMDEs can also lead to surges and sudden stops in specific countries, irrespective of the global financial cycle. Lax capital controls can lead to huge capital inflows, resulting in unsustainable external debt and/or appreciation of the exchange rate that worsens the current account. Worsening macroeconomic imbalances combined with triggers such as a rise in oil prices, default on external debt, turn in the financial cycle, etc, can lead to a sudden loss in international confidence (and capital inflows).

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The orthodox policy advisory for EMDEs to avert the accumulation of macroeconomic imbalances is to choose between a combination of unrestrained capital flows and a flexible exchange rate on one hand, or a fixed exchange rate with capital controls on the other. The underlying trilemma for EMDEs is that they cannot simultaneously sustain an ‘impossible trinity’ of monetary policy independence, free capital flows and a fixed exchange rate. It must choose two out of the three.

While a policy option derived from the impossible trinity rule might work in normal times, as professor Helene Rey of London Business School has pointed out, this might be insufficient to deal with the fallout of shifts in the financial cycle when there is indiscriminate movement of capital in one direction. In such circumstances, EMDEs may have little option other than throwing sand in the wheels of such flows through some forms of capital control and macroprudential policies. The IMF has long abandoned its policy advice for emerging markets to aim for fully-liberalized capital accounts.

Unlike the global financial crisis, EMDEs have not weathered the covid economic storm as well as advanced economies (AEs). Nevertheless, with higher growth, international reserves, lower external debt, inflation and more robust current accounts, EMDEs in Asia are better equipped to weather a US interest rate pivot. Two-thirds of the increase in international reserves of EMDEs since 2001 has been in Asia. Asian EMDE external debt at 20% of gross domestic product (GDP) is way below the EMDE average of 31.5%, and its current account balance is projected at three times the EMDE average. In 2020, EMDEs in Asia shrank at half the rate of EMDEs in general, and their average inflation of 3% is 200 basis point lower than the EMDE average.

Some countries will nevertheless be more vulnerable than others, irrespective of geography. Past experience, especially during the taper tantrums of 2013, when it was widely expected that the Fed would taper its quantitative easing (QE), indicates that EMDEs with weaker macroeconomic fundamentals are hit harder. In 2013, India was among the worst affected countries because its current account and fiscal deficits and inflation were way 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 about 25%.

How exposed is India today to a possible taper tantrum, compared to 2013? At 20% of GDP, India’s external debt is eminently sustainable. Its burgeoning foreign currency reserves also provide an adequate cushion as measured by the Greenspan-Guidotti rule (reserves minus short-term external debt). But both these were also quite comfortable in 2013.

The above table indicates that except for 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 has four of the five selected macroeconomic parameters much worse than the average. Brazil, South Africa and Turkey have two of them misaligned, while Bangladesh and Thailand have one each. India’s nominal current account deficit also doesn’t inspire confidence, as both exports and imports have slid sharply. This could worsen if oil prices rise.

Moreover, five additional vulnerabilities exist that were not in evidence in 2013. First, there is the deadly ongoing second wave of covid, with the pandemic’s epicentre appearing to have shifted to India, and uncertainties over the adequacy of its vaccination programme. Second, India’s outsized decline in growth relative to EMDEs, with the economy contracting by 8% in real terms in 2020-21. The Indian economy is now back, in real terms, to where it was in 2017-18. This comes on top of serial year-on-year declines in growth from 2016-17. Third, there are strong headwinds in the path of an economic recovery on account of India’s impaired banking system. Fourth, both exports and private investment show a long-term declining trend. Fifth, even as India’s budget deficit is higher than the EMDE average, there are headwinds in the way of fiscal correction, as its tax-to-GDP ratio has been trending down, pointing to a broken tax system.

For all these reasons India is particularly vulnerable to the external shock of a rise in US interest rates and turn in the global financial cycle. The country’s macroeconomic fundamentals do not look good in comparison with its EMDE peers. It is also far more exposed than the rest of Asia’s EMDEs. India would do well to watch out.

Alok Sheel is RBI chair professor of macroeconomics, Indian Council for Research on International Economic Relations