The writer is a former governor of the Reserve Bank of India
An inflation rate in the US of 5 per cent in the 12 months to May, well above the Federal Reserve’s target rate of 2 per cent, has fuelled speculation that the central bank might soon start scaling back its pandemic-driven monetary support.
Eight years ago, when then chair Ben Bernanke openly mused that the Fed might start “tapering” its quantitative easing programme, global markets went into a tailspin. Yields spiked, risky assets tumbled and emerging economy currencies crashed. Are we now heading for “Taper tantrum 2.0”?
Bruised by past experience, the Fed has tried to assuage concerns about a surprise policy reversal. Chair Jay Powell has been at pains to emphasise that he will be patient and will not unwind the Fed’s balance sheet without seeing “substantial further progress” in the recovery. Several Fed officials have echoed those reassurances, saying that the Fed would not react hastily to a transient spike in inflation.
Even so, emerging markets are right to be apprehensive about possible market tantrums at home. After all, with extraordinarily loose money supply and low returns in the rich world, emerging markets inevitably become a destination of choice for investors looking for high yields. And when the cycle turns, capital flows revert abruptly, leaving emerging country asset and currency markets in turmoil.
India, one of the “fragile five” back in the summer of 2013, is a prime example of the vulnerability of emerging markets to volatile capital flows. The country was running large current account deficits year on year which were being funded by the easy money unleashed into the global system by QE carried out in rich countries.
We were lulled into complacency, pressure built up and, when the inevitable implosion occurred at the first signal of policy normalisation, it turned out to be hugely disruptive. The rupee fell by more than 15 per cent from peak to trough in the space of just three months, causing enormous loss to growth and welfare.
India has since built up a huge war chest of reserves, often considered the first line of defence against volatile capital flows. But it is learning to its dismay that this is no protection against capricious markets.
Consider the RBI’s policy dilemma during the current crisis. Despite the pandemic and associated lockdowns, India’s stock market is booming, fuelled by the extraordinary amount of liquidity that the RBI has injected into the system as part of its crisis management. As a consequence, foreign capital is gushing in.
The RBI has been in the market almost continuously, buying dollars to prevent an unwarranted appreciation of the rupee. But buying dollars results in extra rupee liquidity which could go beyond the central bank’s comfort level. The RBI could of course mop up the extra liquidity by selling bonds. But such a move would cause interest rates to spike, resulting in the economy being swamped with “carry trade” dollars looking to make money on the yield differentials.
The RBI faces a dilemma. Intervene in the foreign exchange market but leave the resultant liquidity unsterilised (by not selling bonds) and more foreign capital would come in, attracted by the returns in the stock market. Intervene but sterilise the flows and more capital would still come in, attracted by the potential yield differentials. In either case, the economy has to pay the price of adjustment when the easy money reverses tack.
This shows that foreign exchange reserves are at best a defensive weapon for managing the volatility arising from capital flow reversals. They do not help to prevent the build-up of pressure in the first place.
If foreign exchange reserves are not an adequate defence, are capital controls the answer? We know that it is virtually impossible to design capital controls that allow the entry and exit of the right type of capital, in the right quantity at the right time.
To minimise the costs and maximise the benefits of financial globalisation, emerging markets have to maintain huge reserves and keep fiscal and current account balances sustainable. They must minimise short-term debt, especially sovereign debt, in foreign currency and deploy capital controls judiciously and credibly.
As India’s experience shows, even with all those measures in place, such countries still have to grapple with the so-called impossible trinity, according to which no economy can simultaneously have a fixed exchange rate, an open capital account and an independent monetary policy.