Handling external shocks

Following the US Fed's monetary policy lead is not in the interest of emerging economies

Unrelenting global shocks have had negative fallouts for India, as for other countries. But India is one of the few nations where growth is relatively high. India’s size, diversity, the policy space available from good coordination of structural reforms with fiscal and monetary policies, a strengthened financial sector and deleveraged corporate balance sheets, have helped smooth the impact of external shocks since 2020. Can this continue?

The latest shock is the rapid tightening by the US Fed and other advanced economies (AEs). There are pressures to follow the US’ monetary policy. But this is designed for the excess macro-stimulus and tight labour markets in the US. Moreover, interest parity holds tightly only for AEs that are fully open to capital flows. If their policy rates do not rise as much as those of the US, their currency must depreciate, so that expected future appreciation compensates mobile capital for their lower interest rates.

Thus, following the Fed involves letting the exchange rate depreciate while tightening monetary and financial conditions. This is the International Monetary Fund’s (IMF’s) advice for emerging markets (EMs), assuming they always need at least as much tightening as the US. But this could aggravate external shocks, creating sharp price movements in thin markets. Expectations of uncontrolled depreciation and falling growth encourage self-fulfilling capital flight. A sharp currency plunge hurts those who have borrowed abroad but a sharp interest rate rise hurts domestic debtors. Either can push leveraged sectors into crisis. Exporters who typically sell in contested markets gain little, while the cost of commodity imports that are invoiced in dollars rise immediately.

Illustration: Binay Sinha

Blind following

Following textbook theory without keeping the context in mind is dangerous. We are seeing the consequences of demand over-stimulus that ignored supply-chain bottlenecks in AEs’ pandemic response.

The Liz Truss government’s unfunded tax cuts in the UK were particularly inappropriate after a six times rise in the fiscal deficit to 12.8 per cent in 2022. The belief that AE governments can borrow at low rates regardless of the size of borrowing ignores history. Even in the US, that has the advantage of being able to print dollars, inflation, interest rates and deficits were high in the 1970s. After the share of interest payments in the budget reached 25 per cent in the 1980s, fiscal rules were implemented and debt was brought down in the Clinton years. Large fiscal pump priming during Covid-19 has raised debt and inflation again. Interest rates are rising.

In 2020, the IMF told the US it had the fiscal space for excessive fiscal stimulus and is now encouraging the US Fed to overreact to make sure inflation falls to the target. In 2020, its prediction for the 2022 US Fed Fund rate was 0.1 per cent!

Rather than announcing rates will be high for long, or higher than expected, it would be much better for the world’s financial stability if the Fed clearly announced it would condition its rate rise to incoming data. Real sector changes counter the effect of interest rates on markets. For example, strong growth is a positive for markets, allowing them to absorb a rise in interest rates. A slowdown will reduce inflation, allowing the rate rise to taper. This is the advice the IMF should give the US.

EMs would do best to avoid being led into trouble. India did well by avoiding a US-type fiscal stimulus and must now avoid a US-type tightening.  

Pragmatic policy

India’s advantage, even in terms of attracting capital flows and reducing government debt, comes from better growth prospects. To sustain growth while keeping inflation low, supply-side reforms that lower costs and regulate the food economy must continue, supported by counter-cyclical tax rates, a larger share of expenditure on capacity building, an ex-ante real repo rate that does not exceed unity, a competitive real exchange rate without excessive nominal depreciation, as well as use of counter-cyclical macroprudential and capital flow management policies as required.

What makes the above feasible? Growth and reform induced tax buoyancy gives fiscal space consistent with adequate consolidation. Moreover, India does not have full capital account convertibility. Capital flow management policies can be fine-tuned to selectively encourage/ discourage different types of flows. For example, interest-sensitive fixed income flows are capped at 6 per cent of domestic debt markets and are currently less than that. So there is no tight link between domestic and foreign interest rates.

Micro and macroprudential regulation can be relaxed to counter tightening of financial conditions due to outflows. Reserve loss further tightens liquidity but can be sterilised by increasing holdings of government securities. Since credit is just recovering, with stronger regulation, corporate governance and balance sheets, domestic financial conditions can safely stay supportive. Some of the reserves built during inflows need to be used during outflows, while the required precautionary balance is preserved. The surplus reserves are adequate for cyclical US tightening. The dollar has probably peaked as other AEs raise rates aggressively.

A widening of the current account deficit of an oil importer due to a persistent rise in oil prices does require reduction in aggregate demand as well as depreciation —but within limits— since the first can reduce growth below potential and the second can increase inflation and financial instability risk. More than three fourths of imports are intermediates and industrial goods. Energy imports, including coal, have a share of 39.7 per cent in total imports, machinery and chemicals 10.8 per cent, and electronic goods, some of which are inputs in export production, 10.3 per cent. Continuous depreciation is inflationary and results in real appreciation, which encourages more imports. The post-liberalisation reliance on continual nominal depreciation hurt domestic production. The rupee fell from about Rs 8 per dollar pre-reform to above 80, without bringing about a sustained rise in exports.

Therefore, to reduce deficits multiple policy levers are needed. More emphasis should be on longer-term sustainable measures such as encouraging exports, reducing oil intensity and energy imports. World Bank data shows Indian energy intensity has halved from its pre-reform level, partially explaining the limited pass through from wholesale to consumer prices. Coal production and the share of green energy have risen. Service exports and remittances are robust. The ongoing action to increase competitiveness, reduce logistics costs and transport delays will benefit manufacturing exports.

Finally, and most important, policy cannot work against fundamentals. It is the markets that determine asset prices now. Rupee depreciation and stock market correction have been less than in most other advanced and emerging markets. Equity flows have returned recently. This indicates markets are factoring in India’s comparatively better prospects and lower inflation.

The views are personal