The global easing cycle

India will need interventions to protect financial stability

The Federal Open Market Committee of the US Federal Reserve changed its policy path significantly in 2019 to counter rising economic uncertainties, largely due to the US-China trade dispute. The Fed reduced rates thrice in 2019 compared to four hikes in 2018. The latest projections suggest that the US central bank will keep interest rates unchanged in 2020. Meanwhile, the European Central Bank further pushed its deposit rate into negative territory and restarted the asset purchase programme. The Bank of Japan continues to pursue its asset purchase programme to support growth and prices. The policy stance of large central banks suggests that global financial conditions would remain accommodative in the foreseeable future.

 
While the accommodative monetary policy will help support global growth, it could increase risks in the financial system by pushing up asset prices and leverage. Experience shows that the US monetary policy significantly affects global financial cycles. In this context, India will need to guard its interests, and policymakers must make interventions to protect financial stability. A new study by rating agency CRISIL, which has examined both the easing and tightening cycles in recent years, predictably, shows that foreign portfolio investments (FPIs) have been low during the tightening period compared to the easing period. FPI flows were strong during the easing period after the financial crisis, despite the worsening domestic macro situation. However, foreign direct investment (FDI) followed a different path, and was closely related to the domestic economy. India received more FDI during the tightening period than in the easing period, because of higher growth. The Indian economy grew by 7.3 per cent between fiscal years 2014 and 2019. FDI flows have again moderated with the slowdown in the economy. Since FDI is more stable, India will need to revive growth prospects to attract capital of this variety to bridge its savings gap. Higher dependence on portfolio flows to fund the current account deficit could increase financial stability risks. External commercial borrowing also tends to rise with the Fed’s policy easing. Although the Reserve Bank of India (RBI) has reduced policy rates by 135 basis points in the current cycle, it has not translated into lower lending rates and could encourage Indian businesses to borrow from abroad. As reported by this newspaper recently, Indian firms raised $13.74 billion through dollar bonds in the first 10 months of this calendar year, compared with just $1.65 billion in the same period last year.

 
Higher inflows of external borrowing and FPIs could pose challenges for the RBI. It could put upward pressure on the rupee and affect exports. The real effective exchange rate is showing significant overvaluation and has affected exp­orts in recent years, though problems in the implementation of goods and services tax also contributed. However, if the RBI intervenes in the market as it has been doing in the recent past, it will further increase rupee liquidity in the system, which can potentially affect its inflation-targeting mandate. Therefore, in the given global macro environment, India will need to diligently manage and prioritise foreign fund flows. India should create enabling conditions for FDI and avoid increasing dependence on debt flows. Although the current account deficit is likely to remain at a moderate level, a higher flow of dollar debt at a time of slowing growth and rising fiscal pressures could increase risks to financial stability.