A surprise inflation outburst may force rich-world central banks to shrink accommodation
The troubled year ends with bumper foreign capital inflow, thanks to aggressive monetary policies and a vaccine shot to economic prospects. Growth has also recovered faster-than-expected in most countries, including India, China exhibiting outstanding performance. These developments have propelled yield-hunting global capital into emerging markets (EMs) in the last two months of 2020. The economic optimism for 2021 is predicated on the fact that the inflation will remain low in developed countries, maintaining the aggressive stimulus injected by their central banks. A sudden occurrence of inflation is not impossible; repressed demand can come back with a vengeance as most of the population will be inoculated by the second half of 2021. That could force normalisation of monetary policies, raising the risk of capital-flows boom turning into a bust. An abrupt capital flow reversal could be a repeat nightmare of India’s 2013 taper shock as macro vulnerabilities are not too dissimilar—inflation is high, a fiscal position far inferior, while the improved external position with large reserves’ stock does not offer infallible protection.
The up-scaled flow of foreign capital swirling into EMs from November is truly extraordinary. Data from the Institute of International Finance (IIF) on global stock and bond flows reported in the Financial Times (“Foreign investors dash into emerging markets at swiftest pace since 2013”, December 18) shows much of the capital flight in March, estimated $243 billion, has reversed by the year-end. It gathered speed in November, with $145 billion invested—almost $37 billion went into emerging market debt with $40 billion invested in equities. 2020’s end-quarter strength of capital flows into EMs, according to the IIF, matches the first quarter of 2013, i.e., ahead of the Fed chairman’s taper remark-driven stampede out of EMs that year, and exceeds that after the 2008 financial crisis in both time and speed of its return.
India is also benefiting from this munificence. 2020 ends with a three-sixty degree turn in foreign portfolio inflows from the $16 billion exit in March from bonds and equities. While FPIs started trickling back from June, the domestic ride on the global tide is observed in $8.5 billion of net capital inflow in November and almost equivalent received in December so far. Nearly four-fifth of the net $22 billion invested by foreigners in Indian stocks this year entered in the last quarter ($18 billion net). However, foreign investors remain net sellers of Indian debt, taking out -$14 billion to date. This reflects aversion to high inflation and escalated fiscal risks; a Bloomberg report ascribes it to slackened liberalisation towards the inclusion of Indian bonds in global bond indices.
The push and pull forces driving the current boom in international financial flows are quite similar to those in 2013. Inter alia, excessively loose monetary conditions, lucrative returns from relative interest rate differentials and equity valuations in EMs versus developed countries, resurging growth and commodity prices. Global investors perceived little risk against these favourable constellations though some remain cautious due to scepticism about growth normalisation, the looming shadow of fiscal rules and inflation.
At the heart of this boom is a solid belief in low inflation and that major central banks are committed to staying accommodative through the recovery. Views on subdued inflation, reasonably enough, are based upon the enormous slack observed in the labour market or high unemployment, which is likely to restrain wage pressures for quite some time. The US Federal Reserve also modified its inflation target in August to make up for past undershoots, indicating tolerance for higher inflation for longer. Besides, the long-term structural forces of demography, technological shifts, etc, that kept prices depressed in the past one decade remain as before. All these contribute towards sanguineness over the risk of more rapid price growth in 2021 and assurance about a continued monetary stimulus.
This complacency rules out a potential eruption of inflation when consumers in developed countries are freed by vaccination, expectedly in the second half of 2021. However, more than a year of repression could see demand bouncing back with unexpected strength, widening the gap with supply. A nasty inflation surprise could occur, causing asset prices to shift, and triggering portfolio reallocations across the globe.
Even now, alongside the buoyancy in capital flows, there are counter-indications about expected inflation in the US. The 10-year TIPS, the treasury breakeven rate that represents a measure of expected inflation, has consistently risen from its end-September value, 1.6%. At 1.94% in December to date, it is up 34 basis points, although still below the long-term inflation average (2.03%). The 10-year US benchmark bond yield has similarly climbed up, but lower than its December 2019 level at present. It is worth noting that investors are increasingly seeking cover by buying treasury inflation-protected securities, for which the demand has been rising.
This upward momentum could sustain, build up with progressing vaccination, economic pickup and the subsequent unfolding of demand. An unexpected, sharper pickup in inflation with changing expectations about the economy several months into 2021 would affect the amount of money needed in the system, shift interest rates—even a mention of lessening the former would be enough for the world to see another taper tantrum. In June 2013, it was a mere suggestion of an imminent reduction in bond purchases by the then US Fed chairman, Ben Bernanke, that spread panic in bond markets across the world. It triggered an abrupt, large-scale reversal of capital by foreign investors.
Acknowledging the possibility of a capital flow reversal risk next year is useful in order to be better prepared. If a 2013-like taper shock occurs, it will hit India when severe macro difficulties are not very different from seven years ago. For example, high inflation persistence is a resembling vulnerability, which even the central bank believes will endure as it also expects firmer core inflation from various pressures due to, and other than, Covid-19; overseas inflation would be an adverse reinforcement. Two, the fiscal situation is far worse than in 2013, which was preceded by sharp expenditure compression with consolidation in 2012. Comparably, a vastly inferior fiscal position before Covid-19 is further battered by large borrowings and greater accumulation of future debt due to the pandemic. What is significantly improved is the external sector compared to its delicateness in 2013. The large stock of reserves can no doubt help avoid a sudden, discrete depreciation that often results when the capital flow cycle turns from boom to bust. The central bank might even be able to prevent an interest rate response, insulate domestic monetary policy. But, it is debatable if it could maintain monetary intervention to repress bond yields as at present—investors look as keenly at inflation and fiscal metrics as external vulnerability indicators when appraising the value of their investments.
To raise a flag on capital reversal risks is not an agreeable endnote to this forgettable year, especially when the mood is looking up at a strong recovery and a prospective end of the pandemic in the new year. Identifying potential risks, however, is an equal responsibility. This is one such.
Author is a New Delhi based macroeconomist
Views are personal