The period since the Great Recession has been marked by large-scale unconventional monetary policy measures by advanced economies. The most widely debated of these have been asset purchase programmes, which were first launched by the US Fed and Bank of England, and are now being undertaken by the ECB and Bank of Japan. Combined asset purchases under the ECB and Bank of Japan are close in magnitude to those undertaken by the US Fed and Bank of England, and are projected to remain in place till the end of 2016.
Examining FII flows and currency fluctuations in EMEs since 2013, our analysis reflects that periods of unconventional monetary policy—in particular around major announcements such as the QE taper by the US Fed and the implementation of QE by the ECB—have been characterised by increased volatility in both FX and equity markets. It also shows that unconventional monetary policies are not necessarily good for the world.
The episode of “taper tantrum” is still fresh in our memories—the statement from the US Fed on a possible QE withdrawal had sent the emerging market economies, including India, into a tizzy. The rupee, as many said, had gone into a free fall and touched a low of 68 to a dollar in end August 2013. Statistically speaking, the rupee fell by 9% against the dollar between July and August 2013 (from 60.3 to 65.7). Other EME currencies bore the similarly volatile reaction, with most Asian and Latin American currencies tanking after the taper announcement. The Indian government and RBI were quick to respond and announced immediate measures to arrest the volatility and quell the speculation—therefore the actual tapering decision that came in on December 18, 2013, did not impact the rupee in any significant manner.
However, currently the threat of an interest rate hike by the US Fed and the financial volatility it can cause—sometime later this year—looms large. The fear of financial volatility emanates from what was seen during the taper tantrum episode, and the MSCI VIX Index—which is a weighted average of equity indices of 18 EMEs—had risen strongly.
It is interesting to note that through 2014—where no major monetary policy changes were undertaken by the G4 countries—both Indian stock markets and the rupee remained largely stable, except a small bout of volatility around the time of the general elections in May. Chinese stock markets and the MCSI remained stable through the year, only spiking slightly when the Fed announced its principles of policy normalisation in September 2014.
However, the ECB had announced the start of QE in the eurozone on January 25, 2015, and the asset purchases commenced in March, while Japan continued with its policy of quantitative and qualitative easing since April 2013.
The general verdict by international organisations is that spillovers to EMEs from the QE of advanced economies have been largely positive. This estimated positive impact of QE is due to the fact that EMEs have benefited from capital inflows, which have been an important source of investment. In addition, it has been assumed that recovery in advanced economies will benefit EMEs through increased import demand. However, the analysis does not factor in the reverse effect of these policies, which, so far, have been accompanied by capital outflows and large swings in financial markets. Also, with the changed trade dynamics after the Great Recession, it may not be a given that a recovery in advanced economies will lead to an increase in import demand for all EMEs.
On the contrary, the extent of positive spillovers is questionable if we look at the following aspects:
* Despite the large quantity of liquidity entering markets through the ECB and Bank of Japan, EMEs including India, China and Brazil experienced capital outflows and a period of an increased volatility in financial markets, especially from April 2015 onwards. This could be attributed to markets anticipating a rate hike in the US along with strengthening of the US economy and the dollar—thus investors perhaps preferring to invest in the US rather than in EMEs. In addition, the large downswing in Chinese equity markets is leading to an increased risk perception for EMEs as a whole, further exacerbating the flight to safety. EME currencies, particularly in Asia, have been depreciating as Chinese equity indices tanked and this trend is expected to worsen once the Fed hikes interest rates. This effect has spilled over to equity markets, with the Sensex falling 2% during July 27-29, as investors exited Asian markets.
* As a result of the QE, EMEs have become dependent on short-term capital inflows to finance their CAD, as opposed to FDI and exports. This is an unbalanced situation with negative repercussions as EMEs should look at putting in place long-term measures to boost exports so that CAD adjustment becomes sustainable.
Further, according to the recently published IMF Spillover Report, past episodes of sustained dollar appreciation have been associated with crises in emerging markets. Although EMEs are less vulnerable now than they were during the taper tantrum—they have used the interim years to build strong foreign exchange reserves which could act as an insurance against sudden stops in inflows—this has been a costly exercise. In a situation with less uncertainty, these reserves could well be used for long-term investments in the domestic economy, especially in infrastructure.
Moreover, a large proportion of the holders of foreign debt are private sector companies, who do not have recourse to government reserves.
While large reserves do provide reassurance to foreign investors, they may not prove enough if financial conditions become too disorderly. This has been seen recently in China, where despite a large stock of reserves—as well as major efforts from Chinese authorities to carry out rebalancing—they have been unable to fully manage the effects of the equity market shock. Thus, we remain at a risk of contagion from the financial world even when our fundamentals remain strong. To mitigate the impact of what has become the new normal, there is a requirement of creating international safety nets, which will provide access to liquidity in case of a sudden stop or reversals of capital flows. Since negative spillovers arise due to domestic policy actions of other economies, reserve currency issuing countries along with the IMF must give it a serious thought.
(Annapurna Mitra & Kavleen Chatwal, programme executives with the UNDP, contributed to the article)
The author is an officer of the Indian Economic Service. Views are personal