I guess there are two ways to respond to what seems like the impending "tapering" (the word du jour in the financial markets) of the United States Federal Reserve's quantitative easing (QE) programme. One response would be to press the panic button and aggressively lighten positions on all non-dollar assets - including, of course, Indian stocks and bonds. The other is to take a more measured view of things. For this we first need to assess what this "taper" is likely to constitute. Second, we need to identify both the positive and negative impacts of a reduced supply of global liquidity on an economy with the structural characteristics of India. Third, we need to get a handle on other sources of liquidity that could potentially substitute for the reduction in dollar liquidity and how that will affect India.
Well, here's what we know about the likely path of QE. Going by US Fed Chairman Ben Bernanke's testimony to the US Congress in the third week of May, and the minutes of the high-powered Federal Open Market Committee held on May 1 and released around the same time, it is quite possible that some reduction of the size of QE from the current $85 billion a month will start as soon as September. The markets had earlier anticipated the "tapering" would start from the end of this year or perhaps even the first quarter of 2014.
How sharp is the reduction in QE likely to be? Let's not forget that the biggest champion of the QE idea has been Mr Bernanke himself, and this last avatar of QE (QE3) was supposed to be an open-ended liquidity infusion programme that would continue until either growth and employment moved into a comfort zone or inflationary pressures started to build up. Neither has happened. Unemployment might have gone down over the past year, but it remains at a fairly high absolute level of 7.5 per cent. Inflation (as measured by the core PCE deflator, a standard measure used in the US) is hovering at about one per cent and inflation-indexed bonds are pricing in a two per cent inflation rate three years ahead. Besides, like his predecessor, Alan Greenspan, Mr Bernanke is a central banker who is averse to the idea of rattling the financial markets. The upshot is that the Fed chairman might, as a concession to his colleagues, agree to taper but the actual amount of the taper will be mild. My guess is that it is unlikely to exceed $10 billion. Besides, the communication that goes with the announcement will contain all sorts of riders, including perhaps a commitment to ramping it up yet again if macroeconomic conditions turn adverse.
I am not arguing for a moment that non-dollar asset will not be affected if QE is tapered. All financial markets have become QE junkies; even the smallest reduction of the daily dose into their bloodstream will trigger withdrawal symptoms. There are two questions that need to be answered in this context. One, how long will the withdrawal symptoms last? And two, which of the different asset markets gets the worst shakes? I would argue that if the amount of the taper is indeed small, the markets will tend to pull back after a sell-off. In a somewhat extreme situation, it is actually possible that if non-dollar assets are sold heavily in the run-up to the actual taper, the markets could actually rally after the announcement of the taper.
On the second question, my sense is that of the different markets that are vulnerable to liquidity withdrawal, the commodity markets will hurt the most. They seem to be in the early bear phase of a long-term super-cycle and any bad, bad news - whether on fundamentals or liquidity - will drive the cycle further into bear territory. For a net commodity importer like India, that is bound to be good news. Thus, the losses on the capital account from a reduced QE could be at least partly offset by a smaller current account deficit. If my predictions are right, the ratio of the current account deficit to gross domestic product could settle closer to four per cent than to five.
Besides, an important offset to a diminishing QE would be the impact of Japan's quantitative easing of ¥7 trillion a month. Two things are important to note here. Over the last few months Japan has seen net portfolio inflows, driving up the Nikkei, for one thing. This simply means that global markets are yet to see the full effects of Japanese monetary easing. That is likely to diminish as investors start to rethink Japan's actual growth prospects. Recent data from the ministry of finance suggest that capital outflows from Japan are beginning to pick up and, by the time the Fed tapers, yen liquidity outflows could be just about enough to compensate. Second, Japan's exports capital to the rest of Asia are more in the form of cross-border loans than portfolio investment. Thus, the principal sluice through which yen liquidity flows in would be through external commercial borrowings. This might mean that the asset markets will not get as much of a pop as dollar liquidity was giving - but, from an overall balance of payments perspective, we are likely to be okay.
Finally, I am actually comfortable about the fact that the rupee market has been forward-looking and seems to be pricing in, in my opinion, the worst-case QE taper scenario. This means that when it comes to the actual event of the taper, a meltdown in the currency (which usually sets off a chain reaction of short-selling in other markets as well) is unlikely.
My prognosis is the following. Our financial markets will remain volatile for the next couple of months as global investors try to correctly factor in the impact of a taper. But the actual taper itself could bring a sense of stability in the markets. Then the local market will ride on domestic factors - growth, the Reserve Bank of India's stance, the policy environment, and increasingly politics as the elections draw near. Now that's a different story.
The writer is with HDFC Bank. These views are personal
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
