What is happening here? The global markets seem to be losing the anchor. There is neither foothold nor firmness in the ground. And even the ground seems shifting. Just as the recent Himalayan tsunami in North India, a global financial tsunami seems to be on the way. Were global financial environment norms ignored and flouted in recent years?
Embedded in Ben Bernanke?s remark of June 19, 2013, are sufficient hints of the impending unwinding process of the unconventional monetary policy. Hardly five days earlier IMF had advised the Fed to continue to prepare for the smooth exit. Madame Lagarde on June 14 had acknowledged that unwinding is likely to present challenges, including for financial stability. In April, IMF had already warned that the exit would be challenging with many unknowns. Shigenori (2010), in an interesting paper on the subject, based on Japanese experience, observes that the exit is not expected to be smooth. The ?untested? exit strategy being discussed by the US Congressional Research Service (February 2013) has also acknowledged the associated risks.
So, despite lack of well researched academic literature on unwinding of the unconventional monetary policy, at least one thing is clear that the exit will be painful. As there are no standard rules that apply to unconventional monetary policy so also there would be uncertainty in its unwinding. However, the following few select scenarios do look possible. First, the Fed may lower the amount of monthly purchases, which implies that official support to the market declines and lower amount of cash is pumped into the system. Second, the Fed may simply stop purchasing the assets from the market, which would mean that there is no support from the Fed to mortgage and to other bonds. Third, the Fed may start selling the assets that are held in its balance sheet. The increased supply of financial assets, not all of which are ?healthy?, in the market would lower asset prices. The firms may use some of these ?non-healthy? assets elsewhere to obtain liquidity, distorting the market again. Finally, on the understanding that the economy is improving, the Fed may raise the interest rates prompting the FIIs to fly out of emerging market economies (EMEs), requiring global stock markets to readjust. The last two scenarios could also impact the exchange rates of countries, including that of India. How long would this period of uncertainty last? That would be difficult to estimate, but as with any tsunami, it could take two to three years to restore normalcy, as new realignment would need to emerge.
In the world generally professing the efficiency of market forces, a new paradigm has evolved of government successfully bailing out the private sector. Until 2008, the philosophy of ?survival of the fittest? was the main mantra and the businesses that survived were able to withstand the harsh realities of western capitalism. For the last 5-6 years, many in the private sector in the US have got used to living on crutches and now when the financial support will be withdrawn, the resultant behaviour could add to uncertainty. Also, most of the financial institutions in the US were directly dealing with the Fed and must have forgotten the art of dealing with each other?old habits die hard!
Business of business is business, so private sector cannot be blamed for erratic behaviour or swift movement of funds from one market to another. In contrast to the behaviour of the private sector, the government needs to quickly take precautionary measures, being aware of the unleashing of the impending tsunamic forces. As the central banks had jointly moved swiftly and aggressively to counter the malfunctioning of the financial markets in 2008, similarly a joint effort should be explored to examine possibilities of soft landing?if ever there still is a chance. Of crucial importance would be sequencing and speed of unwinding. The issue is of a major concern for the EMEs, especially India, and therefore BRICS could work jointly on this.
There is a good chance that flow of resources to India would suffer and, therefore, the need for liberal norms for FDI should be considered by the government on an urgent basis: portfolio investment, as always, are only fair weather friends. In India, RBI and the government may like to consider a joint committee/study on India?s response to the unwinding of the unconventional monetary policy of the US, and other advanced countries. A scenario analysis of the unwinding would be helpful. The government may also like to provide the market with forward guidance, using the potent tool of communication, which would be useful in stabilising the markets.
The author is RBI Chair Professor of Economics, IIM Bangalore. Views are personal
