Caught off guard by taper

The recent announcement by the U.S. Federal Reserve of a further reduction in its monthly bond-buying programme by $10 billion, to $65 billion, seems to have caught emerging market

economies off-guard. This is quite in contrast to their equanimous reaction in December when the stimulus-reduction programme was launched. This is attributed to the fact that the announcement of January 29 completely ignored the concerns of emerging- market countries. Many of them were under pressure even earlier and the announcement, without acknowledging the volatility that it had already caused, offered no respite to a number of countries, from Argentina to South Africa. Their currencies weakened, in some cases precipitously. Their stock markets fell in conjunction and bond markets reacted violently. Threatened with a possible choking of easy money, investors started selling emerging market stocks and currencies to invest in the developed countries that offer better risk-adjusted returns at this juncture. Predictably, many central banks of developing countries hiked interest rates to stabilise their currencies, but with mixed results. India has shown greater resilience this time compared to many other similarly placed economies, and even in relation to its record last September when the news of a possible tapering sent global markets into a tizzy. Improved macroeconomic fundamentals and the RBI’s determination to check inflation have boosted investor confidence. However, given that growth rates are still sluggish and given the possibility of fiscal slippages, India will continue to faces challenges. Over-reliance on short-term flows to bridge balance of payments has been the bane of external sector management, and at times like this the policy shortcomings stand exposed.

There are two broad lessons to be drawn from the taper and the reactions to it. RBI Governor Raghuram Rajan has pointed out that policy coordination among countries has been a casualty. In the immediate post-crisis period, emerging economies helped boost global demand through well-coordinated fiscal stimulus programmes. A complete synchronisation of monetary and fiscal policies might not be possible in practice but certain seminal policy measures such as the U.S. taper do require wider consultation and coordination among countries. This has been the consensus view at several forums — including the G-20 and IMF-World Bank meetings. Second, it needs to be noted that U.S. monetary policy is framed with reference to the U.S. economy. The gradual withdrawal of the stimulus is dependent on the U.S. economy reaching some well defined milestones such as reduction in unemployment. The ongoing taper signals a stronger U.S. economy, and that should be good news for India and other emerging economies — at least in the long run.