The threat of tapering

Recovery in the US economy is still too shaky to turn off the QE tap

Till the cloudburst in Uttarakhand hit us, tapering was the most dreaded word in India. Having said that, tapering is unlikely to take place in September. Not even this year, if US Fed Chairman Ben Bernanke sticks to the promise of linking tapering to an acceptable rate of unemployment.

The first hint of tapering led to a global sell-off. However, the moment the US Q1 2013 gross domestic product (GDP) growth was revised down to 1.8 per cent from an earlier estimate of 2.4 per cent, markets all over the world heaved a sigh of relief since it indicated that the US economy was not in a healthy enough shape to warrant a tapering.

The fact is, despite some positive signals, the US economy is still in trouble. The effect of sequestration is yet to be felt. Also, except for QE1 (the first quantitative easing programme), the rest has generally been a failure. The very fact that inflation remained benign, shows that liquidity bypassed the real economy and muscled its way through the financial economy, seeking returns, ignoring the risks. As the charts show, not surprisingly, both money and debt productivity have taken a hit.

The GDP growth was revised downward as consumers spent less than previously thought, while investment was anaemic. For an economy that is heavily dependent on consumer spending, creation of adequate jobs at sustained level holds the key to recovery. However, the growth in the number of jobs in the US has been very low; the slowest among post-recession periods since the great Depression. A Royal Bank of Scotland study shows, approximately 50 per cent of the jobs created were low-paying ones, including large number of part-time jobs. Further, the improvement in the unemployment figures is more statistical than real given the large number of discouraged workers. This also explains why the share of profit in the GDP is at an all-time high while that of wages is at an all-time low. Clearly, the situation is not ideal for domestic demand to pick up and prop the economy.

While part of the recently experienced increase in domestic demand can be attributed to the wealth effect of booming stock prices and spurt in house prices (engendered mainly by low finance costs), consumers who significantly de-leveraged earlier have also started to re-leverage.

Clearly, therefore, this is not an ideal situation since any hint of increase in rates would cause consumers to de-leverage, while house prices get hit as demand wanes. It is this fragile nature of the recovery that will ensure that the Fed keeps the tap open. However, sustaining of high asset prices would have required macro indicators surprising on the upside. Unfortunately that's not the case, either in developed markets or emerging markets. Given this, it is quite unlikely that liquidity will rush back with the same vigour as earlier.

The mere threat of tapering led the foreign institutional investors to withdraw a whopping $7.2 billion from the Indian markets in June. Given the weak outlook for the Indian economy for the current financial year, hot money will more likely trickle in. On the other hand, the current account deficit for the current year is unlikely to show a marked improvement. The
biggest challenge, in this case, would be financing it. One should, be prepared for the rupee to remain weak this year.

The writer is a Delhi-based independent economist

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