During the Taper Tantrum of 2013, India’s macro stability came under significant pressure. Last year, in contrast, India’s macro stability was unscathed despite the most aggressive global monetary tightening in four decades. What changed in 10 years?
The tantrum that was
This year marks the 10th anniversary of the Taper Tantrum of 2013. In these months a decade ago, at the first hint the Fed would taper the avalanche of liquidity it had injected following the 2008 crisis, global financial markets threw a tantrum, inducing a “sudden stop” of capital flows into emerging markets. The consequence: mayhem across several economies that had become reliant on fickle portfolio flows to finance large current account deficits. India was one such example and, along with Turkey, South Africa, Brazil and Indonesia, saw its external sector come under relentless pressure in the summer of 2013.
The rupee gapped down almost 20 per cent between May and September that summer, engendering inflation and financial stability concern. In response, Indian policy makers mounted an interest rate defence to stem the pressure on the rupee and then turned to a subsidised Non-Resident-Indian (NRI) deposit to augment foreign currency (FX) reserves. The tide finally turned, but it was a tempestuous monsoon.
The tantrum that wasn’t
Last year, emerging markets were subject to another bout of pressure – again the collateral damage of Fed actions. Scrambling to normalise monetary policy, the Fed started raising rates in 75-bp increments, which sucked capital away from the “periphery” to the “centre,” and caused the US dollar to surge to its highest level in 20 years. Simultaneously, the Russia-Ukraine war caused oil prices to spike. For a capital and commodity importer such as India, a stronger dollar alongside higher crude prices was a double-whammy, pressuring both the current and capital account simultaneously.
While the external sector was under sustained pressure for much of 2022, it did not show up in outsized rupee depreciation vis-à-vis other emerging markets. In fact, the rupee depreciated among the least compared to its peers when the pressure was on. But this was only because the Reserve Bank of India (RBI) aggressively intervened and sold dollars — to the tune of almost $90 billion across spot and forwards — between June and October last year.
Make no mistake, the pressure last year was every bit as acute as the Taper Tantrum. How can one tell? To compute pressure holistically one needs to normalise and combine both FX movements and FX intervention. Just focusing on the former is misleading, because it could simply reflect the policymaker’s preference for using the exchange rate as a shock absorber. Instead, when one combines both dimensions in a standard Exchange Market Pressure (EMP) index it’s clear that the pressure confronted last year was equivalent to the Taper Tantrum and second only to what was encountered in the global financial crisis.
Yet, nothing cracked in India. No extraordinary interest rate defence was necessary. In fact, the interest rate differential between India and the United States progressively narrowed as 2022 went on and the Fed upped the ante. Yet, no external capital had to be mobilised and no special measures had to be invoked in India. In short, policymakers never lost control.
If the exogenous pressures were the same across 2013 and 2022, why were outcomes so different across the two episodes? What changed over the decade?
Buffers matter, perceptions matter even more
One of the most important lessons Indian policymakers learnt from the Taper Tantrum was that buffers — in the form of FX reserves — matter. More importantly, perceptions of buffers matter even more. Not only must policymakers possess an arsenal of firepower to serve as “self-insurance” in a policy-crisis world, but be seen to be doing so.
Back in 2013, India had adequate FX reserves, on paper. At the time, FX Reserves were equivalent to almost six months of imports, and almost equal to gross financing requirements (current account deficit plus all debt coming due in the subsequent 12 months) for a year, considered sufficient by conventional standards. Yet, markets were not convinced. This created a Catch-22 situation for the central bank. “Intervene” – and reduce buffers further, thereby accentuating the perception of inadequacy. “Don’t-intervene”, and risk an overshooting of the rupee, begetting more weakness.
Unsurprisingly, therefore, since 2013 the RBI has used every opportunity to accumulate FX reserves and build up a war-chest. At the start of 2022, for example, FX reserve cover had swelled to almost $670 billion from $280 billion in 2013. This amounted to 1.8 times gross financing requirements and 10.5 months of imports. What this allowed the RBI to do was to intervene expansively during moments of stress without creating any doubt that the central bank possessed sufficient firepower.
The self-insurance imperative is particularly relevant for current-account deficit countries such as India. In the case of East Asia, FX reserves were built-up after the 1998 crisis by running sustained current account surpluses. These were “earned reserves”. In India’s case, reserve accumulation came from absorbing capital inflows. These are “borrowed reserves” that have a commensurate liability in the economy which can be unwound at any time.
Fundamentals matter
Buffers, however, can only serve as the first line of defence and buy time. They cannot substitute for mis-aligned fundamentals beyond a point.
Apart from the fiscal deficit – discussed below – two of the most important policy variables from a macro stability perspective are real interest rates and real exchange rates. After the global financial crisis and in the run-up to the Taper Tantrum, real interest rates in India – when measured against core CPI inflation -- remained deeply negative, suggesting monetary conditions were exceptionally accommodative and explaining the desire of households to hoard gold, which further pressured the balance of payments.
All that changed immediately after the Taper Tantrum. A review committee was constituted in September 2013 that suggested a move to Flexible Inflation Targeting (FIT): An explicit targeting of headline CPI at 4 per cent, a tolerance band around it, a definition of failure, and the constitution of a Monetary Policy Committee. A de-facto move to CPI-based targeting started almost immediately in January 2014, an MoU was signed between the RBI and the government in February 2015 and the RBI Act was formally amended in 2016 to incorporate Flexible Inflation Targeting – arguably one of the most important reforms of the last decade.
The move to flexible inflation targeting marked a regime shift in the setting of real interest rates. Real rates moved more decisively into positive territory from early 2014 itself and remained there till the pandemic struck. While they were in negative territory during the pandemic, they’re back in positive territory – and currently at pre-crisis levels -- after last year’s monetary normalisation by the RBI.
An equally important policy variable on the external front is the real exchange rate. Between 2007 and 2011, India’s REER had appreciated almost 15 per cent in four years, creating concerns that the rupee was overvalued and encouraging speculators to take the other side during episodes of stress in 2011 and 2013.
In recent years, however, the broad REER has been flat. To be sure, the REER has appreciated over the last decade but the average appreciation has been 1-2 per cent a year and been accompanied by positive growth differentials between India and her trading partners, suggesting the equilibrium REER may have also risen in tandem. That said, we continue to believe some REER depreciation will help India’s global competitiveness, especially given how the underlying CAD has evolved, as discussed below. But there is no widespread market perception of a large misalignment at the moment.
Imbalances matter
The fact that both internal (real interest rates) and external (real exchange rates) policy fundamentals have not been misaligned, has contributed to maintaining both internal and external balance in recent years.
Inflation outcomes, for instance, have been much better than commonly presumed, until the pandemic struck. From the advent of de-facto inflation targeting (January 2014) until the pandemic commenced (March 2020), inflation averaged just 4.7 per cent, half the level (9.6 per cent) witnessed in 2012 and 2013. When the IT framework was, de facto, adopted in early 2014, headline CPI inflation was still running close to 10 per cent. For starters, the 8 per cent and 6 per cent interim-inflation-targets under framework were achieved sooner than envisaged. Then, from January 2016 to December 2019, headline CPI averaged exactly 4 per cent -- the inflation target.
To be sure, inflation is determined by a variety of factors, and has undoubtedly benefitted from relatively benign global commodity price inflation over the last decade. But the fact that the RBI had an unambiguous and transparent mandate to keep inflation close to 4 per cent, and certainly below 6 per cent, has been a key contributor.
Over the last three years, the combination of the pandemic and the war has expectedly thrown things off-track, with headline CPI averaging 6.1 per cent since the start of 2020. However, the MPC’s sustained rate normalisation last year suggests the committee appears determined to keep inflation within the target band. Equally important is the MPC’s repeated reference to bringing inflation back to the 4 per cent target. Doing so will be crucial to retaining the sanctity of the framework and anchoring expectations.
Similarly, external imbalances have remained within sustainable levels, for the most part. The CAD has averaged just 1.3 per cent of GDP from early 2014 to just before the pandemic. To be sure, it has benefitted from lower crude and commodity prices and the fact that banks and corporates were undergoing a deleveraging process, which has pushed-out a private capex cycle.
That said, even as the headline CAD has remained contained, the underlying CAD will need some watching. Ex-oil and gold, India runs a current account surplus, but one that has progressively reduced over the last decade. This speaks to external competitiveness challenges and increases the vulnerability from a commodity price shock. Therefore, prioritizing external competitiveness — including though calibrated Rupee depreciation — will need to be a key focus area.
Unfinished business: fiscal
Despite the manifold gains made in recent years, some work still remains. Consolidated public sector borrowing requirements (PSBR) — at 9 per cent of GDP — are still very elevated. Reducing this is important not just from a debt sustainability perspective, but to ensure external imbalances don’t flare-up. At its most fundamental level, the current account deficit is simply the investment-savings gap of the economy, which is the sum of the consolidated fiscal deficit and the investment-savings gap of the private sector. If a private capex cycle is to get-going, it will necessarily reduce the private sector’s net savings. For this not to cause pressure on the current account, it must be accompanied by the public sector reducing its dissaving. India’s Achilles Heel has been of not creating enough fiscal space in the good-times. It will therefore be crucial to meet this year’s fiscal targets and then front-load fiscal consolidation after next year’s election.
Never waste a crisis
Even as some work still needs to be done — reducing fiscal deficits, bringing inflation closer to 4 per cent and working on external competitiveness – this must not detract from the lessons learnt and significant gains made on macroeconomic stability over the last decade.
That India was able to avoid another “Taper Tantrum” in 2022 was not by accident, but the result of fortifying itself over the last decade through building a war-chest of FX buffers, adopting an inflation targeting framework and ensuring policy variables were not misaligned.
But macro-stability is a strange beast. Its costs are very visible. But, unlike growth-enhancing reforms, its benefits are often intangible. Success is sometimes measured by what is avoided (a crisis) rather than what is achieved.
It’s therefore crucial to avoid any slip-sliding-away. Instead, the gains achieved over the last decade need to be reinforced and advanced. That would be the best way to commemorate the 10th anniversary of the Taper Tantrum.
(Sajjid Z Chinoy is Chief India Economist at J P Morgan. All views are personal)