Beggar-Thy-Neighbour....
Call it beggar-thy-neighbour central banking (policy to cure one’s own economic problems at the cost of other countries). Interest rates around the world are coming down. While the reason is weak inflation in some countries, growth is sluggish in others. In commodity exporting countries such as Australia, Canada and Russia, monetary authorities have cut interest rates to propel exports through competitive devaluation. While in many other developing countries, lower commodity prices (i.e. crude) have eased inflationary pressure, making it easier for central banks to ease official rates to stimulate domestic growth.
From a broader perspective, low inflation and controlled twin deficits are sine qua non (prerequisite) for a loose monetary policy. But the competitive pressure on central banks to undertake monetary easing, in multiple cases, has come at the cost of staving off malaise that plague their respective economies. This kind of ‘one-downmanship’ has made many countries vulnerable to external shocks (e.g. Fed Rate Hike) because their relatively weak macroeconomic fundamentals do not support a loose monetary policy.
Twin Deficits: Key to Emerging-Market Vulnerability….
India was amongst the fragile five (others being Brazil, Indonesia, South Africa and Turkey) that bore the brunt of Fed’s unilateralism during the year 2013. It was struggling with high inflation and ballooning twin deficits (current account and fiscal). As a result when U.S. Federal Reserve decided to taper its monetary stimulus, markets exploded and flight of international capital resulted in sharp depreciation of the rupee. However, since then, fundamentals have improved a great deal. Inflation has come down, current account deficit (CAD) is under control, and the government has reiterated its commitment to a lower fiscal deficit target. This episode underscored a critical lesson that a country's vulnerability to external shocks (e.g. Fed's taper tantrum) is largely a function of investors' perceptions about underlying macroeconomic fundamentals.
In order to numerically represent the vulnerability phenomenon, the Economic Survey (Government of India) 2014-15 constructed a macroeconomic vulnerability index (MVI) which combines the rate of inflation, CAD and fiscal deficit of a country. The index value can be compared across countries for different time periods to gauge their relative vulnerability. According to the survey report, in the year 2012, India was on top of the list on vulnerability with an Index value of 22.4, comprising of 10.2% inflation rate, 7.5% combined budget deficit (Centre and States) and 4.7% CAD.
For the purpose of this analysis, we reconstruct the index for the years 2014 and 2015 and conclude that, though India’s macroeconomic vulnerability has come down substantially since 2012, there is no room for complacency as the index value is still slightly above the threshold limit of 12 (index value below 12 with 4% inflation, 2% CAD and 6% fiscal deficit is a safe macroeconomic territory).
U.S. Rate Hike? Is It Déjà Vu All Over Again....
A research paper from the Federal Reserve Bank of San Francisco notes that not all emerging markets suffered equally in the taper-related selloff that began in May 2013. Those with structural weaknesses in their economies suffered the most. But despite berating the Federal Reserve for the tapering tantrum, now when a rate hike in U.S. looms closer, many developing countries are yet to align their monetary policy with their existing macroeconomic realities to stay on the right side of the ledger.
Since January 2015, 37 central banks across the globe have taken actions on the interest rate front. While 27 have slashed it, 10 have done the opposite (see Table 1 & 2). But not all policy actions announced by the central banks are consistent with their respective country's MVI score or its individual threshold limits (see policy actions highlighted as 'Inconsistent' in Table 2). These countries either suffer from fiscal or current account imbalance, or from high inflation. Yet central banks in these countries have chosen to undertaken monetary easing.
In this context, given the downward trajectory of inflation, CAD as well as fiscal deficit in India, RBI's monetary stance is very much in line with the country's prevailing macroeconomic conditions. And if the government and the RBI walk the talk on - the inflation target of 4% and fiscal deficit at 3% of GDP by 2017, with CAD consistently being contained at 2% of GDP - future MVI score could well be within the safe macroeconomic territory thereby increasing the room for further easing.
