Fed Reserve determined to end the QE party

FOMC's hawkish tone suggests tapering to start this year; bonds and equities might come under further pressure

Emerging markets like India can no longer take capital flows for granted. The minutes of the Federal Open Market Committee's (FOMC) meeting on July 30-31, released late on Wednesday, clearly suggest all economic indicators are looking up in the US. In the month of June, manufacturing expanded, the unemployment rate remained stable at 7.6 per cent and real personal consumption expenditure rose marginally. On the back of positive data, the FOMC has stated: "If conditions continued to develop broadly, as anticipated, the Committee would reduce the pace of purchases in measured steps and conclude the purchase program around the middle of 2014." Economists say the tapering is going to be data-dependent.

No prizes for guessing that this would be negative for India. A combination of local and global factors could very well drive foreign investors from financial assets. Foreign institutional investors have been net sellers in debt and equity since June. Since June, FIIs have sold $9 billion in bonds and $3 billion in equities. The market is expecting a rather dovish commentary so the tapering news has come as a negative surprise.

So, how will this impact India? For one, currencies of emerging markets would remain under pressure, as capital flows reverse. Indian bonds could suffer a lot more than equities, believe experts, for several reasons. Tirthankar Patnaik, chief economist at Religare Capital Markets, thinks more than the rupee's fall, the RBI's flipflop has really confused FIIs. Only a month ago, the central bank was announcing open market sales to increase rates of long tenor bonds. Now it is has reversed its strategy and nobody knows which way long tenor rates will move. The other reason why Indian bonds could see a sell-off is because India is not part of any emerging market bond index, a structural issue.

The spillover of this confusion may also happen on the equity side. FIIs so far have sold equities worth $3 billion and many expect this to accelerate in the coming months. Vikas Khemani, CEO Edelweiss Securities, believes while Indian bonds at this point of time are not necessarily attractive for FIIs, the story is slightly different for equities. He believes FIIs might find it difficult to pull out large sums of money. If FIIs were to sell equities worth $5 billion, the index would fall by 20 per cent. Also, there are several other FIIs and private equity players willing to take a contra bet on India at this point, explains Khemani. But the bottom line is this: India's policymakers cannot take flows for granted any more and need to make policy a lot more consistent.