Posted in Finance Articles, Total Reads: 2057
, Published on 03 August 2014
Due to the recession of 2008 there was a huge liquidity crunch in the US market. In order to overcome this crisis, Federal Reserve, the central bank of United States, implemented “Quantitative Easing” a policy under which they started buying long term financial assets from private institutions (banking as well as non-banking) every month to affect the long term interest rates. The aim was to create new money for use in the economy to boost demand and reduce the interest rates actually faced by the companies and public as the standard monetary policy had become ineffective in doing so. This resulted in increased investments in real assets because of low cost of borrowing money thereby increasing the demand and eventually leading to an increased output.
Investors who considered US to be a safe haven for their money were forced to move it out of the country because of the near to zero interest rates in the country on investments made in financial assets. They found higher interest rates in the emerging economies like India, Malaysia and Indonesia. Some part of the huge amount of money supply generated by the US fed in an attempt to stimulate the economy was used to purchase Indian currency in order to make investments in India. This led to weakening of dollar against rupee because of the increased demand of the latter. This money was invested in India in the form of foreign direct investment and foreign institutional investment. This happened in spite of weak corporate fundamentals and deteriorating economic conditions. Although it helped the economy in the form of investments, it also made it vulnerable to the shocks of currency outflow.
In May 2013 Ben Bernanke, the US federal chief said that the US economy is on the path of recovery, unemployment rate has come down, inflation has picked up enough and if it continues this way the fed will taper the quantitative easing i.e. it will reduce the amount financial assets bought by the central bank in late 2013 and by mid-2014 quantitative easing will be stopped. This had huge negative impact across the globe especially in emerging markets. The stock market in India crashed along with the bond market which touched the lower circuit limit.
Due to this announcement investors in US started selling bonds in the US market owing to the fear that once the fed stops buying bonds its price will start coming down. As a result the interest rates started rising in the country and bond prices started falling. It created a favorable environment for the investors who had invested their money outside the country. They started pulling out their money from nations like India to invest in US markets. The major reason behind this was the considerably less risky investment environment available in the US for investment as compared to emerging countries like India. This happened at a time when India’s current account deficit and fiscal deficit were alarmingly high. The foreign investors who had earlier invested rupees in the Indian market sold their holdings in return of US dollars. This investment was made in form of bonds, equities and other direct investment. So after the announcement bond market, share market and the commodity market fell drastically.
With the easy money available due to quantitative easing Indian companies have access to foreign money by an instrument called external commercial borrowing. If the easing is actually stopped in the near future it will put a lot of burden on these companies who have raised floating rate debt from the global market because of the low interest rate. As the interest rate rises their interest payment on that debt will increase. These companies have taken debt mainly to expand their business globally through acquisitions and direct investments.
During this time it was noted that the currencies of other emerging economies fell 2% – 4 % whereas in India the fall in currency was about 9%. India’s slow economic growth with a GDP of 4.5-5 percent is a major reason for lack of foreign inflows into the country. India is running a twin deficit of current account and fiscal deficit. The current account deficit is mainly due to the import of commodities like oil and gold. Due to more imports than exports Indian companies have to pay more in dollars than what they get. This trade deficit is compensated by the capital inflows from foreign countries. If foreign investors start taking out their money then it becomes difficult for the government to balance the deficit. The government has to either burrow money or the central bank has to use its foreign reserves. This is accompanied by high inflation, weak economic fundamentals. So the tapering was not the only reason for rupee depreciation.
In September 2013 the decision to taper quantitative easing was postponed to everyone’s surprise. The fed said that it needed more evidence to confirm that the US economy is on track. If they go for QE tapering now it may slow the pace with which US economy is growing. This brought some relief to capital and currency markets in India. It also gave time to the policy makers in India to improve long term growth prospects and economic fundamentals.
To put the blame on US fed for causing chaos in the Indian market instead of weak fundamentals is totally illogical. The US fed is made to protect the interest of US economy and not global economy. The government of India and the RBI should take steps to improve investment and growth opportunities in India so that these external factors have minimal effect on the Indian markets. With improvement in macroeconomic data (current account deficit 1.7% in the last quarter), stabilizing rupee and rate cuts by RBI, the Indian economy seems to be in a better position as compared to few months back.
This article has been authored by Rahul Rai from TAPMI
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