India Must Watch Out For A Taper Tantrum In Global Capital Markets

Context: Indian economy is vulnerable to a reversal of capital flows that might occur if the US Fed decides to tighten its monetary policy.

About Taper Tantrum:

• In May 2013, the US Fed’s announcement that it would taper its massive bond-buying programme that had been on since the global financial crisis led to a sudden sell-off in global stocks and bonds.
• This triggered capital outflows and currency depreciation in many emerging market economies that received large capital inflows.
• This episode earned the nickname taper tantrum.

Factors impacting the macroeconomic stability and economic growth of Emerging Markets and Developing Economies (EMDE):

• External factors: Linked with the spill overs from global financial cycles, determined by Fed’s monetary policy.
  • Fed easing tends to whit risk appetite, sending a surge of capital to EMDEs in search of higher yield.
  • Conversely, tightening raises bond yields, sucking capital back to the US.
  • For e.g. During the taper tantrum of 2013, India was among the worst affected countries, because its current account and fiscal deficits and inflation were way above the EMDE average.
  • India was among the ‘Fragile 5’, the other four being Brazil, South Africa, Turkey and Indonesia, with the Indian rupee falling about 25%.
• Internal factors: Can also lead to surges and sudden stops in specific countries.
  • Lax capital controls can lead to huge capital inflows, resulting in unsustainable external debt and/or appreciation of the exchange rate that worsens the current account.
  • Worsening macroeconomic imbalances combined with triggers such as a rise in oil prices, default on external debt, turn in the financial cycle, etc, can lead to a sudden loss in international confidence (and capital inflows).

Challenges with the EMDEs in averting the macroeconomic imbalances

• Sustaining impossible trinity: Simultaneous balancing of monetary policy independence, free capital flows and a fixed exchange rate becomes impossible, and only two of the three can be chosen.
  • Moreover, policy options derived from the impossible trinity rule might be insufficient to deal with the fallout of shifts in the financial cycle when there is indiscriminate movement of capital in one direction, i.e. towards the US.

Vulnerabilities of India in the light of possible taper tantrum:

• India is the only country among eight major emerging markets that has four of the five selected macroeconomic parameters much worse than the average. Refer picture ->
• India’s nominal current account deficit also doesn’t inspire confidence, as both exports and imports have slid sharply. This could worsen if oil prices rise.
• Deadly ongoing second wave of covid, and uncertainties over the adequacy of vaccination programme.
• Decline in growth relative to EMDEs, with the economy contracting by 8% in real terms in 2020-21.
• Impaired banking system.
• Both exports and private investment show a long-term declining trend.
• Trending down of debt-GDP ratio, pointing to a broken tax system.

Conclusion: For all these reasons, India is particularly vulnerable to the external shock of a rise in US interest rates and turn in the global financial cycle.