Emerging resilience

Domestic policies have helped emerging-market economies

Rolling back of the pandemic-era policy accommodation and a sharp increase in the policy rate by the US Federal Reserve since March 2022 intensified fears of “taper tantrum 2.0” across emerging-market economies (EMEs). Despite concerns, however, emerging markets, including India, have shown remarkable resilience. This shows, while policy tightening in the US and other developed economies can disrupt financial markets and tighten financial conditions in EMEs, strong domestic fundamentals can help safeguard the economy from adverse economic shocks. A recent analytical article by economists at the Federal Reserve Bank of San Francisco strengthened this argument.

The article looked at the changes in 10-year government bond yields for 16 EMEs to evaluate the global market response to the onset of policy tightening by the Fed. The results showed that a one standard-deviation increase in current account deficit (CAD) in EMEs led to a 40-basis-point increase in 10-year government bond yield spread over the first half year after the onset of policy tightening. This statistically significant relationship showed that countries with current account surpluses exhibited lower changes in spreads and were better positioned to absorb the policy tightening than countries with CAD. Further, pandemic-related fiscal spending on health and social welfare was found to have a negligible impact on changes in 10-year bond yield spreads. This may perhaps also be because countries spent less due to existing fiscal constraints. Thus, a large CAD in EMEs can be regarded as a bigger macroeconomic flaw going into episodes of sudden tightening of global financial conditions.

The “taper tantrum” occurred in 2013 when the US Fed announced its plans to taper the quantitative easing programme started after the financial crisis of 2008. The announcement led to a “sudden stop” of capital flows into EMEs like India. This not only led to capital outflows, but India was also running a large CAD, which needed to be financed. The episode inevitably resulted in a sharp fall in the external value of the rupee. Notably, India was not alone in facing this crisis. Several EMEs faced similar conditions and India was made part of the “fragile five”.

However, things have been very different this time. India has managed the situation particularly well, which has led to reasonable stability in the currency market. The Reserve Bank of India (RBI) used every opportunity to accumulate foreign exchange reserves. It was helped by the sharp increase in capital flows in 2020 after large central banks, particularly the Fed, flooded the system with liquidity. India’s foreign exchange reserves swelled to over $640 billion in 2022.  While the sudden increase in global interest rates and a sharp move in commodity prices owing to the Ukraine war led to outflows in 2022, the situation was managed well by the RBI. The adoption of inflation targeting in India and other EMEs, as highlighted by economist Kenneth Rogoff in these pages recently, also helped. India and other EMEs could move more freely in terms of monetary policy action, which helped improve confidence in financial markets. While the RBI has done well thus far, and the moderation in the CAD has helped, risks to macro stability remain. Low risk appetite among global investors, worsening geopolitical conditions, and persistently high fiscal deficit can increase challenges.