Quantitative Easing Tapering And Its Impact On The Indian Economy
Posted in Finance Articles, Total Reads: 7774
, Published on 24 February 2014
What is quantitative easing?
Usually, all central banks use officially set interest rates for proper regulation of economy. These rates are radiated out to the rest of the economy while lending and paying back of loans, mortgaging of assets or return on the money assigned for savings. But when the interest rates reach sky high, borrowing of loans become difficult and the ability to spend decreases thus, attracting saving and decreasing demand. Lower interest rates have an opposite effect.
But interest rates cannot go below zero as the effect on the economy will go down thus, slowing the growth of the country. When economic growth slows down and the interest rates begin to approach zero, the central bank uses the open market operation of Quantitative Easing to ease down the situation by pumping in money into the economy. The money is not directly infused or in other words, there is no direct printing of currency notes. It is done rather electronically. The central bank buys assets more commonly in the form of government bonds, equities or corporate bonds from commercial banks or other financing companies. This encourages banks and other financial services companies to lend bonds. The interest rates keep changing depending on the purchases made on assets.
Thus, the price of the assets bought by the central bank increases and the interest rates fall. With the help of easy and cheap borrowing due to lower yields, the central bank is able to increase spending power of common people and thus, create more demand pulling the economy out of recession. Consumers spend and borrow more money which in turn stimulates the economy. Now there is greater demand for goods and services, employment rate increases and the amount of disposable income in the hands of the common people also increases. This also keeps a check on inflation and the inflation rate is under control.
Moreover, the currency of the home country depreciates due to quantitative easing. The lower interest rates attracts domestic investors to engage in investing activities. This money can further be invested overseas. The cheaper currency in turn stimulates foreign trade as well.
Risk associated with QE
The money generation effects of quantitative easing are not as rosy as they seem. Rather, the risk associated with QE keep increasing with the increase in money infusion. There are many risks that could be of concern to various investors and policy makers.
Due to ease in the economic scenario, more money circulates in the country which increases the demand. This increase in demand increases the spending capacity of people which has direct upward effect on the price level of everyday commodities. The competition among various goods and services increases which leads to an increase in prices thus encouraging inflation. The rise in inflation can lead to deregulation of prices and disposable incomes which can lead to an inefficient economy.
The policy of quantitative easing can put the country in danger as well. The image of the country for its fellow countries might become negative as many countries can have the perception that the practice of quantitative easing is not a means of actual growth for a country. It is not leading to real economic success as the money is being directly injected. For instance, some countries resisted investing in US because of quantitative easing. So this may cause a threat to the currency of the country.
Another risk is that the increase in confidence among consumers and businesses may lead to excessive borrowing by them. A certain amount of debt can help stimulate the economy but excessive debt can create problems. In addition to this, quantitative easing can also create government deficit.
QE in the United States of America
The biggest investment bank in the US, Lehman Brothers went bankrupt in Aug 2009 and on Nov’09 the first round of Quantitative Easing QE-1 as it is now called was announced by the US Feds. After the Lehman crisis other major banks were on the verge of following suit. This could have been out of greed to earn more or a poor decision or whatever may have prompted them, all had huge mortgage backed securities in their portfolio. After the housing bubble crisis and the Lehman Bankruptcy, these securities were of no value and in the balance sheet they were nothing but a NPA (Non-Performing Asset) for banks. This is when the Feds came in to rescue and an agreement was reached between the banks and the Feds. The agreement was that the Feds would buy $100billion worth of mortgage backed securities from the banks every month and ease the burden on their balance sheet. The round lasted for 17 months starting Nov’09 which is the longest so far. In FY’09 the US economy contracted by 2.8% compared to .8% previous year. Unemployment touched an all-time high of 9.3% compared to 5.8% previous year. However, in 17 months i.e. by Jan 2011, the data showed some signs of relief. The GDP after two years of contraction finally expanded by 2.5% and both gold and gas increased in value by over 50% indicating that investment had enabled demand at least at the face value.
Overview of US economy FY09-10
Real GDP (YoY %)
CPI (YoY %)
10-Year Note (%)
Budget(% of GDP)
Meanwhile about 10000 miles away in India it was all happy go lucky. Many believed the century belonged to India and China and why not, in the last decade the economy grew at an average of 7-8%. Per capita income had almost doubled. Because of a tightly regulated financial system (Banks, Stock Markets), India was able to absorb the recession relatively better than most of the globe. A more introspective analysis of the Indian economy in the post-recession era would confirm this. In FY09,the 27 nation European Union contracted by .6% and the US economy contracted by 2.8% while the Indian GDP grew by 6.6%(lowest in last five years) . Exchange rate was 46.53 which showed that rupee was very stable.
By Jan’11, there was relief for the Feds as pointed out earlier that the demand had picked. However, there was no sign of improvement in the labor market. Unemployment rate shot up to 9.3 % in FY’09 from 5.8% in the previous year. Despite QE-1, the GDP growth was back in track to positive numbers but the labor market remained in a limbo. Unemployment rate in FY10 was 9.6% and in FY11 was 8.9%. This prompted the Feds to start another round of quantitative easing in Sep 2012 which is still there and is expected to be withdrawn by March 2014.
Impact on Indian Economy
Quantitative easing or the printing of money is the easiest way to stimulate economic growth that involves a lot of risk not only for the home economy but for the world as a whole. In 2011, before the first round of tapering, the 10 year Indian govt. paper gave a yield of 7.92% and the Rupee Dollar exchange rate was 44.71. However, in 2011 when the first round of tapering begun in the US, FIIs assumed a short position in the Indian Bond market selling in huge volumes. Thus, the price of G-sec fell and the yield rose to 8.55% because of huge selling and the FIIs took more dollars along with them out of the country. The Balance of Payment equation which was earlier balanced turned skewed because of the change in current account.
Balance of Payment (Bop) = Current account + Capital account
A country should ideally have bop=0 i.e. it is a zero sum game. A deficit in current account should be filled by a surplus in capital account. The payment side of current account includes imports, outward remittances by NRI. Similarly, the earning side is mainly from exports, inward remittances by foreigners or money sent by NRIs to their family. The capital account part in bop mainly includes investments by FIIs and FDI. India has a chronic trade deficit problem. So to keep our bop zero we need our capital account to be surplus. One of our major import is petroleum products and in the last few decades since the post 1991 era, we have been getting a lot of dollars via the FII and FDI route which have financed our imports and kept our forex reserves intact.
In 2011, India’s current account deficit was close to 5% of the GDP. This was significantly higher than an average of 3-3.5% in the previous year. Because of weak macroeconomic sentiments coupled with weak demand across the globe, policy logjam in India, corruption and poor governance, no new significant investments could be capitalized. Thus, the capital account did not increase as much as required to offset the deficit in the current account. We know that bop must be zero but if the capital account surplus is not enough to offset the deficit in current account, the payment is made using the country’s forex. In 2011, when the Feds announced first round of QE tapering, the demand for dollar surged up through two ways in India. One was the fixed demand of 10billion$/day by OMC(oil marketing companies) and the second was the demand by FIIs who were pulling their money out of Indian capital markets in the hope of a better yield on the Treasury bills. The rupee slide to a low of $53 in FY11. This sliding was stabilized when the Feds announced the second and third round of easing. This phenomenon was just a warning to the Indian govt. and the sign of how volatile the Indian currency is to the tapering of Quantitative Easing.
By the beginning of 2013, everyone was waiting for the US economic data. The GDP had grown by 2.8% and in May 2013, Ben Bernanke, former US federal reserve head made a statement whose reverberation echoed all around the world. He said that based on the improved economic scenario, the Feds might consider tapering very soon. In FY 13, Indian economy grew by a decadal low of 4.8% and the rupee-dollar exchange rate was 54.99. When Mr. Bernanke announced that tapering might start very soon, in the hope of a better yield on US treasury bills there was chaos across the world market, particularly in India. FIIs across the world shorted their position in most of the developing markets (Bombay Stock Exchange, National Stock Exchange, Nikkei, Hang Sang etc...) in the hope for a better return in the US. In India, CAD in the previous financial year FY 13 was 4.8% of GDP, consumer price index (CPI) was at 9-10% and wholesale price index (WPI) was at 6%. On Aug 28, 2013 rupee touched an all-time low of 68.85 against one dollar. Indian Forex Reserve was at $276billion. The demand for dollar grew on two fronts. One was the high import of non-essential commodities particularly jewelry and gems and the other was the demand of dollars by OMC (Oil Marketing Companies). On the import front, the finance minister of India Mr. Chidambaram took a prudent step of increasing the import duty on Gems and jewelry from 2% to 10%, thus restricting imports to some level and reducing the burden on the bop situation. On Sep 3, the new RBI governor Raghuram Rajan assumed office. He had a big task in his hand and had to fight on multiple fronts. One was inflation and the other was rupee depreciation. In the first review meeting, after he assumed office he raised the repo rate by 25 basis point (1% equals 100 basis point). On the rupee depreciation front, the governor opened a special swap window for the OMC to fulfill their daily dollar demand. By using this swap window, the OMC could buy dollars from RBI at current market exchange rate instead of the open market and return it to RBI later. This eased the demand for dollars to some extent now on the supply of dollar. RBI has opened a swap window for FCNR deposit as well.
The Road Ahead
On Sep 18 US fed chief Ben Bernanke announced that tapering would not begin in near future. This coupled with steps taken by RBI and the north block to increase the supply of dollars and restrict the import of non-essential commodities gave rupee a resistance at 64 and a support at 62. However, tapering cannot continue forever and as speculated by many economists, it should begin by mid next year. Improving infrastructure and fast clearance of projects is the need of the hour which would improve investor sentiments and make India a favorable investment destination all around.
This article has been authored Ankit Mittal and Sreyoshi Gupta from IMT Ghaziabad
1. Data used in the article has been taken from Bloomberg.
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