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31 October 2014, Gateway House

India needs an anti-tapering strategy

India faces heightened geoeconomic risks as the U.S. exits its unconventional monetary policy and the value of the dollar appreciates against major currencies. We can mitigate the risks with a multilateral safety net to provide liquidity, and by attracting FDI through the ‘Make in India’ programme

Former Senior Fellow, Geoeconomics Studies

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New geoeconomic risks are threatening global economic stability and India will have to craft a crisis response plan as these risks—arising in the developed world—start unfolding.

The first risk to the global economy is the tightening grip of deflation in various rich countries—the U.S., UK, members of the European Union, and Japan—while inflation persists in the emerging economies. The developed world is trying hard to nudge prices up, while emerging economies such as India, South Africa, Turkey or Brazil are struggling to tamp down rising prices.

These diametrically opposing economic conditions have yielded contrary monetary policies. Central banks trying to pull up the inflation curve have kept interest rates extremely low, virtually near zero percent. In contrast, emerging economies have kept interest rates high to discourage prices from climbing further.

This gap in interest rates makes money behave like a liquid: it flows to assets offering higher returns. As a result, capital flows from developed economies have sought better returns through growing investments in Indian equities, bonds, and foreign currency loans to private sector companies.

Both forms of inflows—portfolio investments and external commercial borrowings— represent potential sources of risk. And in fact the risks have started materialising. The Federal Reserve bank announced on October 29 that it is exiting its quantitative easing programme (or QE, under which it bought a fixed amount of bonds from the market every month) because it can sense green shoots of growth in the U.S. economy.[1] In addition, the Fed has also hinted that it plans to increase interest rates in 2015.

As the Fed stops buying bonds, it will invariably affect the state of liquidity in global markets. When liquidity dries up demand also evaporates, forcing asset prices to head southwards. Investors and lenders then rush to liquidate assets to avoid booking a loss. When that happens, expect some outflows from India, which will have an impact on current account deficit and subsequently, through the exchange rate, on inflation.

On foreign currency borrowings, the risk is home-grown: most corporate borrowers have not hedged their foreign currency exposure in the hope that the rupee-dollar value will move in a narrow band, or in the misguided expectation that the Reserve Bank of India (RBI) will intervene to protect the exchange rate. In fact, the RBI’s repeated exhortations to corporates to hedge their foreign borrowings have been largely ignored. The extent of hedged exposures was revealed by RBI deputy governor H. R. Khan recently: only 15% in July-August 2014 against 35% during 2013-14.[2]

If tapering—and a subsequent increase in U.S. Fed rates—do lead to the rupee depreciating (as it did during May-August 2013 when news of tapering first broke), the unhedged exposures will translate into a higher debt burden. At the macro-level, this represents a financial stability risk for the country.

The RBI attempted to introduce an indirect penal provision by forcing banks to make higher provisions against unhedged foreign currency exposures of their corporate clients. But that did not help. Banks claimed they do not have access to data; also, banks cannot force a company to hedge their foreign currency exposures.

Some solutions have been suggested—for example, the Mint newspaper recommended that the RBI should convince the Institute of Chartered Accountants of India to discipline unhedged corporates.[3] But it might be too late by the time it is implemented.

The risk to India gets aggravated because of a schism building within the developed bloc: while the Fed exits its accommodative policy, the European Central Bank (ECB) is planning to launch a stimulus programme to stir up growth in somnolent Eurozone.[4]  On interest rates too, the ECB has differed from the Fed by remaining noncommittal. In both these economic zones, interest rates are virtually close to zero percent.

The deviation in strategies, and the first signs of economic growth in the U.S., have resulted in the dollar value appreciating. This adds to the risk profile of emerging markets, including India: a stronger dollar will induce many investors to dump emerging market assets in favour of less riskier U.S. treasury bonds.

Two risk mitigation strategies exist. One has been suggested by Reserve Bank of India governor Raghruam Rajan in an April 2014 speech.[5] Rajan has recommended a multilateral safety net to provide liquidity to emerging markets when developed country central banks unwind their unconventional monetary policies.

The second is the “Make in India” programme launched by Prime Minister Narendra Modi, which seeks to increase the share of manufacturing in the economy’s GDP. If properly implemented, the scheme can act as a magnet for foreign direct investment, which is an acknowledged source of stable foreign investment, compared to the relatively fickle portfolio inflows.

Rajrishi Singhal is Senior Geoeconomics Fellow, Gateway House. He has been a senior business journalist, and Executive Editor, The Economic Times, and served as Head, Policy and Research, at a private sector bank, before shifting to consultancy and policy analysis.

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[1] Board of Governors of the Federal Reserve System, Press Release, 29 October 2014, <>

[2] Khan, Harun R, Indian Foreign Exchange Market: Recent Developments and the Road Ahead, 6 October  2014, Reserve Bank of India, <>

[3] Dugal, Ira, ‘Unhedged forex exposures continue to haunt RBI’, Mint, 9 October, 2014,  <>

[4] Draghi, Mario, Introductory Statement to the Press Conference (with Q&A),  European Central Bank, 2 October 2014,  <>

[5] Rajan, Raghuram, Competitive Monetary Easing: Is It Yesterday Once More?, Reserve Bank of India, 10 April 2014, <>