Tapering Tapered Off?

By Michelle Cherian

It is a common saying in financial circles that “If the FED sneezes, the whole world catches a cold.”  The saying did hold true last year when Federal Reserve’s Chairman, Ben Bernanke’s unprecedented and unsolicited announcement to taper its Quantitative Easing Programme caught emerging markets off-guard and threw them into a tizzy.

As a famous English song would well, sing, let’s start from the very beginning.

The terms ‘Quantitative Easing’ and ‘tapering’ exploded into the financial lexicon early last year in May, with the FED chief’s announcement, but they are not new to the US. The Federal Reserve employs the instrument of Quantitative Easing to stimulate growth in the economy when reduction of short-term interest rates to even, say, 0, fails to do so. It is a method to print money electronically (something uncannily similar to the Indian method of ‘Deficit Financing’) and purchasing of bonds by the Central Bank from the Government. The rationale behind this move is to pump money into an economically ailing economy, increase the purchasing power of the general public and thus inflate demand to such an extent that production activity picks up. The US was facing critical unemployment woes and a drastically low inflation rate in 2012 ahead of the Central Bank’s decision to open the money-liquidity tap.

Sure, Inflation has been projected as a gross evil for any Economy but mild inflation is an indication that the economy is on the right track, by which is meant, the Growth Track. This is primarily because inflation occurs when there is a persistent rise in the general price level which occurs due to increase in aggregate demand by a country’s people, industries and governments. If there is demand, there is production and sequentially there is growth.

Now, let’s explore Quantitative Easing a bit more in detail. It is nothing more than an asset swap between the Federal Reserve and the US; Government, private sector and all. The FED buys bonds from the Government and the private sector and releases liquid cash into the economy. This prompts banks to cut down interest rates in order to incentivise people to borrow money, and thus to use a phrase, this would be killing two birds (those of increasing DEMAND and INVESTMENT) with a stone. These nouveaux riche, if one may say so, because through public eyes it does seem so, did miracles for the emerging markets, especially India. They increased the demand for our perpetually under-performing Exports and when the balance of trade in India turned positive, Foreign Institutional Investors (FIIs) began eyeing our economy with renewed interest. Capital flows started streaming in and the Indian Economy was growing at 9.3% as reported by THE HINDU.

In this hunky-dory situation, one may ask, where is the scope for the anxiety mentioned at the beginning of the article. It all began when the FOMC (Federal Open Markets Committee) convened a meeting on the 22^nd of May last year to revise the Monetary Policy drafted by it. During the meeting, Ben Bernanke went on record to say, “If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings … take a step down in our pace of purchases.” In other words, the then FED chief had hinted at ‘Tapering the QE programme’.

Why did he do so? It shouldn’t come as a surprise. Quantitative Easing was never intended to be permanent. Excess money supply in the economy would lead to hyper-inflation, a situation almost impossible to surface from. As the US feels that its growth is improving, it could reduce its bond purchases as now it would be able to afford the liquidity crunch. With unemployment levels falling and Inflation inching upward towards the desired 7%, the decision to taper the QE was pretty legitimate. However, Bernanke also stated that the decision to do so would be data-dependent, meaning that if need be, if future reports suggest that the economic slow-down the decision could well be reverted.

The mere mention of these plans alerted the FIIs and they pulled out their funds and the confidence they reposed in our markets, in search of better future prospects in the US. The reduction in bond-purchases, reduces their prices and spikes up their yields (Bond prices and bond yields share an inverse relationship), making them more lucrative for the FIIs than the Indian securities. As these investors left the Indian markets in droves, withdrawing the money they held in India as Securities, we were left with a surplus cash situation, more surplus than required or desired. Increase in supply always leads to fall in price, in this the increased supply of Rupees lead to a fall in its price, i.e a fall in its price in relation to the dollar (Exchange Rate). Other reasons such as diminishing investor confidence and decreasing demand for the Rupee only made matters worse and the Rupee’s value started on its free-fall journey.

The currency plummeted to its all-time low in August, recording 68 points as against the dollar. With the rupee failing to rise in value, despite the RBI’s piecemeal attempts at raising short-term interest rates, the current account deficit and import bills got augmented. P Chidambaram, Finance Minister of India, released a slew of measures, among which the most publicised and thankfully, the most effective was the decision to increase the gold import tariffs, owing to the gold fever which most Indians seem to possess. Again the Government’s rationale behind this move was to reduce imports, because imports were being paid for in rupees, which was steadily depreciating in value, and this would mean paying more rupees for a dollar, thus expanding import bills.

All this happened because of ‘proposed tapering’. Had Tapering actually happened would the result have been more drastic? That is indeed something to ponder about.

The QE programme has been lauded for its effectiveness and on that front, Bernanke and present FED chief, Yellen are in consonance. Bernanke had stressed at future meetings that the tapering will not be unexpected or sudden but a more gradual process. In fact, the tapering has already begun, with its first phase in December, when the FED reduced bond purchases from its original $85billion to $75 billion. The process will predictably continue GRADUALLY all through 2014, with the US Central Bank shutting off the liquidity tap at the end of the year.

Since the initial scare of tapering, India has come a long way. Economic Analysts and newly appointed RBI Governor, Dr. Raghuram Rajan, opine that India is currently in a better position to face Tapering as it comes, when it comes.

Rajan’s taking up office as RBI head came as welcome news for the financial markets which felt that now the tide would turn for the better. He took a number of bold initiatives, such as improving communication between the Central Bank of India and the Indian markets (something his predecessor was blamed for not having done) and announced plans to subsidize hedging costs for banks so as to attract foreign funds. Capital flows have now begun to enter Indian markets with renewed vigour, though still not matching upto the pre-tapering days. Also our CAD is on the decrease owing to the decline in rupee value which to an extent did help pick up exports. Moreover, a stronger US economy would only boost our exports so this should come as a silver lining-in a dark cloud- sort of news.

Economic Affairs Secretary, Arvind Mayaram, mentioned during an interview with NDTV that India has strong economic fundamentals and relying on its economic history, India has seen positive capital flows, barring 2008, so the anxiety is pretty much unbiased. He went on to say that the Rupee has held ground since September and hopefully, should stay that way.

Though Tapering of the QE will not have its touted impact, as its mere mention did, the Indian Economy is still shaky and continues to prove itself as uncertain territory so the new RBI chief and other regulators should watch their step. The warning bells have been rung, albeit a bit prematurely; all that is now required is to respond to those warning bells with the right measures and appropriate implementation.

Think we can achieve that?

The author is is currently pursuing Economics (first year bachelors program) at St. Stephens College, Delhi. She is passionate about singing, reading and writing. She has remained an integral part of her school editorial team and is an aspiring writor-editor in college too. Her greatest strength is that she believes in herself and that belief gets reflected as conviction towards her work. She wishes to pursue Economics as her field of study by specialising in the branch called Developmental Economics.