With a major global event around the corner that could potentially change the dynamics of international financial markets completely, this is perhaps the wrong time to write something on currencies. I am referring, of course, to the possible taper of the US central bank's (Fed) quantitative easing (QE) 3 programme that might be announced after the Fed's high-powered open market committee (FOMC) meet on September 18 and 19.
Most analysts are going with the assumption that the taper would be gentle with a reduction in monthly liquidity infusion by about $10 to 15 billion from the current $85 billion. They are also convinced that the communication that goes with it will ensure two things. First, rule out an abrupt end to the programme and second, assure the markets that the decision to taper does not in any way mean that the Fed will start raising interest rates. These assumptions are baked in adequately into current exchange rate levels at least for emerging markets (EMs). I would argue that even if there were a small sell-off in these currencies (in a somewhat Pavlovian) response to the announcement itself, it is unlikely to last too long.
The assumption that the Fed will go easy on the taper is premised on two things. First, long-term interest rates in the US have moved up sharply over the last few months and could derail the growth engine when it has just about started to rev up. The 30-year mortgage bond rate for instance is close to 5 per cent and is already showing signs of dampening the housing market that in a sense, has led the US recovery.
Second, while the headline unemployment number has come off sharply to 7.3 per cent from the 8 per cent-plus levels that prevailed just about a year ago, there are serious concerns about the "quality" of improvement in the labour market. For one thing, some of the improvement in labour market conditions appears to have come from a drop in the "participation" rate. Thus, with the persistent sluggishness in the economy in the post financial-crisis, people have been discouraged from looking for jobs. This has reduced the size of the labour force, making the unemployment numbers look better. Only 63.2 per cent of adult Americans participated in the labour force, the lowest level since 1978. As the economy picks up, these "drop-outs" from the labour force could be back in the job-queue pulling the jobless rate along with it
These seem like convincing arguments against a quick taper but with every prediction there are risks. The milder risk is that the taper is not announced at all and the market starts to price it in from December. This could bring an immediate sense of relief too, but it would also bring back the uncertainty about what the Fed is likely to do next. The long wait for the taper to begin has also brought a sense of fatigue to the markets and a further delay will certainly add to this. Fatigued traders are known to place curious bets and volatility could increase as a consequence.
The bigger risk is that of the Fed announcing a more aggressive schedule (I would say an immediate reduction of, say, $20 billion would constitute such an event) than the gentle wind-down we all seem to be assuming. This might be what economists call a low-probability event but might not be such a bizarre decision after all. For one thing, quantitative easing as an idea is no longer the flavour of the season and there are hardly any die-hard supporters in the FOMC, except Ben Bernanke himself. Besides, the fact that bond yields have risen despite fully active easing has been used by economists (including influential academics like Michael Woodford) to argue that QE is not a robust line of defence against rising yields.
What happens if this risk materialises? It should not be difficult to predict that EM currencies, stocks and for that matter anything that had ridden up on the back of the liquidity glut, would reverse course again and shed value against the dollar. For EM currencies (including the rupee) there is another factor that needs to be considered that could make the task of defending them against heavy depreciation far more difficult. The last round of depreciation came against the backdrop of easy global liquidity conditions. Ask any Indian company that was borrowing trade credit, for instance, and the answer is likely to be that not only were dollar funds available, they also came cheap.
This easy liquidity situation could disappear if the taper is aggressive. Thus, the Reserve Bank of India (RBI) would have to face the task of handling the demands of local industry that could be starved of dollar funds. This involves a trade-off - jettison the tight liquidity strategy currently in place and risk another round of rupee depreciation or let local industry remain liquidity starved and try and to save the rupee. Let's keep our fingers crossed and hope that the RBI does not have to make this choice.