By: Punam Sharma
With Greece deciding to hold a referendum to assess its people’s acceptability to creditors’ demands, the drama has certainly taken a turn for the worse. Greek banks have been temporarily shut and capital controls levied while the European Central Bank (ECB) has decided not to further hike its emergency liquidity support to the Greece central bank. Our objective here is not to assess timelines in the crisis nor hazard the extent of contagion that it may result in. There are more informed quarters closer to the ground who are already engaged in answering these questions. Rather we want to delve on 2 fundamental perspectives that we think are quite relevant for local investors when they evaluate the situation.
Investors may feel especially concerned since the ‘taper tantrum’ of 2013 is still relatively fresh in memory. Then the RBI had to abruptly reverse a monetary easing cycle and financial assets had sold off aggressively. Beyond the usual arguments that have since circulated with respect to how much ground India has covered in plugging its macro-economic vulnerabilities, we want to highlight the following points:
- 1. The Genesis of the Crisis: The 2013 taper tantrum was on account of an expectation that the Fed will taper its asset purchases since the strength of the US economic recovery didn’t need that level of accommodation. Meanwhile emerging markets (EMs) had been so used to this ultra dose of liquidity that they had forgotten to keep their macro-economic house in order (remember India’s USD 88 billion current account deficit?). So when the crisis struck EMs had to act in panic and not all succeeded in stabilizing their houses the way India did. However, there was very little take-away from the tantrum for the US Fed; save some finger wagging from the rest of the world that the world’s largest central bank should take into account the ramifications of its policy on other markets. So long as the Fed could defend its core mandates of price stability and maximum employment and so long as this mandate wasn’t getting changed, there wasn’t really a tangible incentive to act against volatility in other markets. Only when the strength of the dollar tightened financial conditions sufficiently to start influencing the Fed’s core mandates, did the central bank take explicit cognizance of these developments.
The current situation, should it balloon into a crisis, is quite different. The genesis of the crisis won’t be because of fear of removal of policy accommodation because growth in a large economy is stabilizing. Rather, it will count as a potential shock to the global financial system just when global central bankers are in the midst of stabilizing their growth versus inflation trade-offs. To that extent if the crisis persists, we would expect the large 3 central banks around the world (US, Euro, Japan) to incrementally turn more dovish. This is also true since every one of developed market central banks knows a simple fact: That they have spent most of their ammunition in the 7 years since the 2008 financial crisis. Should the world economy slump into another growth collapse, they simply don’t have the policy space or tools to do this all over again. Better then to address incremental risks proactively via incremental action, rather than risk doing the whole play-book again.
- 2. India’s Fundamental Changes: India’s move away from the so-called fragile 5 is well documented. We are often talked of as the emerging market that has covered the most distance since the 2013 crisis; both in terms of key macro-economic parameters like inflation, fiscal, and current account but also in terms of policy stability both from the central bank and the government. We would like to draw attention here to one key parameter here that essentially tracks India’s dependence on foreign capital flow. The parameter can be termed as ‘basic balance’ and essentially tracks the sum of our current account deficit (CAD) and our net foreign direct investment (FDI). Since FDI typically denotes the sticky long term flow, the parameter essentially tracks our reliance on the more volatile components of capital flow, including foreign portfolio investments. The chart below tracks this:
As can be seen there was a steady deterioration in our basic balance between 2009 and 2013. But the risk was masked by the global liquidity glut that resulted from the large central banks’ balance sheet expansion programs. Thus when the music threatened to stop (or taper!) in 2013, we needed almost USD 70 billion flows of the so-called volatile nature in order to balance our balance of payments (BoP). It is no wonder that public policy first moved to address currency and external risks at the cost of everything else. Not doing so would have thrown India into a true funding crisis. As opposed to this, in FY 15 we ran a surplus on basic balance. This means that even if we had received nothing under the volatile components of debt, equity, or banking flows; we would have net added to our BoP. This is similar to our situation in 2008 when the RBI had been able to exclusively focus on the growth risks of the financial crisis and not worry too much about other aspects of financial stability.
The points we have made here do not mean that our markets will be immune to developments in Greece over the short term. Rather, if our assessment is right, we would focus on the following takeaways:
- If the crisis should accentuate, the likelihood is strong that large global central banks will tone up their dovish stance and / or actions in order to mitigate the adverse effects of the crisis on their core mandates : inflation and / or employment. This is especially true as they don’t have the policy ammunition left to underwrite the recovery all over again.
- While short term capital flows may cause stress to the rupee and incremental dollar accretion, India now runs a basic balance surplus which means that RBI’s reaction function is likely to be quite different from what it was in 2013.
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