Fear of tapering

Now, India's policymakers must focus on domestic bottlenecks

As expected by many, the United States Federal Reserve Board decided to begin the tapering of its asset purchase programme, widely known as QE3, in the meeting of the Federal Open Market Committee (FOMC) this week. The taper initially involves reducing purchases of mortgage-backed securities from $40 billion a month to $35 billion and those of government securities from $45 billion to $40 billion. Although the FOMC statement released after the meeting clearly said that the pace of tapering could change depending on economic conditions, the starting rate of $10 billion per month was very much in line with market expectations and is unlikely to be disruptive of markets. The FOMC went further in trying and preventing the kind of turbulence that global markets went through last May, when even the mere possibility of the taper sent them into a frenzy. Seven months later, both markets and policymakers appear to have learnt their lessons from that episode. For the former, given the slow but steady recovery in the US economy and stronger indications of stability in other regions, a gradual withdrawal of liquidity can easily be made up for by improved fundamentals. For the latter, even as the taper is being carried out, it was important to signal that it would be a slow, calibrated and closely watched process. Further, even as the "unconventional" component of monetary policy (the asset purchases) is rolled back, the "conventional" component (interest rates) is going to remain at its current low levels for some time to come.

It appears, then, with regard to tapering that it was less to be feared than fear itself. A relatively smooth transition to a normal monetary position by the US Federal Reserve boosts confidence about both the sustainability of this necessary change and the capacity of the global economy to withstand it. From the perspective of emerging markets in general and India in particular, yes, less dollar liquidity will have some impact on capital inflows and, consequently, on currencies. However, the fear factor that drove these between May and September is far less significant now and the impact is likely to be much smaller. In the Indian case, the heightened vulnerability that came from the massive current account deficit a few months ago has also reduced drastically, with the current account deficit falling to below two per cent of gross domestic product during the July-September quarter, a relatively comfortable level.

However, taper or no taper, the fact that the Indian economy might show far better shock-absorbing capacity now than it did a few months ago should not lull policymakers into a false sense of security. The current account deficit may be at a safe level now, but there are several structural reasons why it can very quickly re-emerge as a problem and a source of external vulnerability. The current account deficit is still bearing the burden of lower iron ore exports and higher coal imports, reflecting developments over the past three years. Both these signify a sharp departure from the economy's competitive advantage emerging from its natural resources, for which corrective responses are urgently needed. With external risks contained, the government needs to refocus on such domestic bottlenecks.