 "Lagarde underlines risks from strengthening dollar")
Many challenges lie ahead for the global economy, of which these two are particularly relevant for India, she said in an address at the Reserve Bank of India headquarters here.
The first challenge is the recent strengthening of the dollar on the relatively strong US recovery, combined with the divergence of monetary policy paths in advanced economies. This has put pressure on countries whose exchange rate regimes are linked to the dollar but yet conduct a substantial share of their external trade in other currencies. Countries which have borrowed heavily in foreign currency also face pressure.
The dollar's rise is also putting pressure on the balance sheets of banks, companies and households that borrow in dollars but have assets or earnings in other currencies.
“India’s corporate sector, which has borrowed heavily in foreign currency, is not immune to this vulnerability. Corporate sector debt has risen very rapidly, nearly doubling in the last five years to about $120 billion (Rs 7.54 lakh crore),” she said.
The second challenge is prospective normalisation of monetary policy in America and its spillover to emerging markets. The risk of financial market and capital flow volatility, along with sudden increases in interest rate spreads, remains a real possibility as US interest rates begin to rise.
Unconventional monetary policies, including large purchases of government debt, were used to provide accommodation in advanced economies since the 2008 global financial crisis. These have had both positive and negative spillovers. The policies helped avoid a financial market meltdown in the initial stages and later supported a recovery in advanced economies and elsewhere. However, the vulnerabilities that got built up during a period of very accommodative monetary policy could unwind suddenly when such policy is reversed, creating substantial market volatility.
The world got a taste of it during the “taper tantrum” episode in May and June of 2013, when most emerging market economies suffered indiscriminate capital outflows. India was also affected.
If market volatility materialises, central banks need to be ready to act. Temporary, though aggressive, domestic liquidity support to certain sectors or markets might be necessary, with targeted foreign exchange interventions.
Praise for RBI
There are a few examples where good fundamentals, as well as decisive and swift policy responses, helped countries reduce and cope with market volatility, said the IMF chief and India is an example.
RBI took decisive action during and after the taper tantrum episode. It provided foreign currency liquidity support to key sectors, allowed the rupee to depreciate and provided judicious foreign exchange interventions to minimise disruptive movements in the rupee.
RBI also arrested the surge in gold imports, narrowed its current account deficits sharply and started to rebuild foreign exchange reserves. In a very short time span, India successfully contained its domestic and external vulnerabilities, more than in many other emerging economies, Lagarde added.