With the economic recovery improving and inflation higher than expected in the United States, the Federal Reserve has signaled that it may reduce its bond purchases. The International Monetary Fund (IMF) in its April 2021 World Economic Outlook raised the possibility of capital outflows from emerging markets and developing economies (EMDE) in the event of a turnaround in the financial cycle, heralding instability. for them.

EMDEs have long been exposed to surges and sudden stops in capital flows which from time to time undermine their macroeconomic stability and economic growth. The sources of such exposure are both internal and external. The external source is related to the fallout from global financial cycles. The Fed’s monetary policy is a major determinant of these cycles, since the US dollar is effectively the world’s reserve currency. The easing of the Fed tends to whet the appetite for risk, sending an influx of capital into EMDEs in search of higher returns. Conversely, the tightening increases bond yields, sucking capital into the United States. The internal policies of EMDEs can also lead to surges and sudden stops in some countries, regardless of the global financial cycle. Lax capital controls can lead to huge capital inflows, resulting in unsustainable external debt and / or an exchange rate appreciation that worsens the current account. Worsening macroeconomic imbalances combined with triggers such as higher oil prices, a default on external debt, a turnaround in the financial cycle, etc., can lead to a sudden loss of international confidence (and inflows of capital).

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The macro comparison

The orthodox policy advice for EMDEs to avoid the build-up of macroeconomic imbalances is to choose between a combination of unlimited capital flows and a flexible exchange rate on the one hand, or a fixed exchange rate with capital controls on the other. go. The underlying trilemma of EMDEs is that they cannot simultaneously support an “impossible trinity” of monetary policy independence, free capital flows and a fixed exchange rate. He must choose two out of three.

While a policy option derived from the Impossible Trinity Rule might work under normal circumstances, as Professor Helene Rey of the London Business School pointed out, it might not be enough to deal with the fallout from changes in the cycle. financial when there is indiscriminate movement of capital. in a sense. In such circumstances, EMDEs may have little choice but to throw sand in the wheels of these flows through some form of capital controls and macroprudential policies. The IMF has long since abandoned its policy advice for emerging markets in favor of fully liberalized capital accounts.

Unlike the global financial crisis, EMDEs have not weathered the covid economic storm as well as advanced economies (EAs). Nonetheless, with higher growth, international reserves, lower external debt, more robust inflation and current accounts, EMDEs in Asia are better equipped to withstand a pivot in US interest rates. Two-thirds of the increase in international EMDE reserves since 2001 has been in Asia. Asia’s EMDE external debt at 20% of gross domestic product (GDP) is well below the EMDE average of 31.5%, and its current account balance is projected at three times the EMDE average. In 2020, EMDEs in Asia were halved compared to EMDEs in general, and their average inflation by 3% is 200 basis points lower than the average for EMDEs.

However, some countries will be more vulnerable than others, regardless of their geography. Past experience, particularly during the crisis crises of 2013, when the Fed was widely expected to ease its quantitative easing (QE), indicates that EMDEs with weaker macroeconomic fundamentals are hit harder. In 2013, India was among the hardest hit countries because its current account and budget deficits and inflation were well above the EMDE average. India was among the “5 fragile”, the other four being Brazil, South Africa, Turkey and Indonesia, the Indian rupee having fallen by about 25%.

To what extent is India today exposed to a possible tantrum compared to 2013? At 20% of GDP, India’s external debt is eminently sustainable. Its burgeoning foreign exchange reserves also provide an adequate cushion as measured by the Greenspan-Guidotti rule (reserves minus short-term external debt). But both were also quite comfortable in 2013.

The table above shows that with the exception of the current account deficit, all the parameters that made India vulnerable in 2013 are again significantly above the EMDE average. India is the only country among eight major emerging markets where four of the five selected macroeconomic parameters are well below average. Brazil, South Africa and Turkey have two misaligned, while Bangladesh and Thailand have one each. India’s nominal current account deficit also does not inspire confidence, as both exports and imports have fallen sharply. It could get worse if oil prices rise.

Additionally, there are five additional vulnerabilities that weren’t evident in 2013. First, there’s the ongoing deadly second wave of covid, the epicenter of the pandemic appearing to have shifted to India, and the uncertainties. as to the adequacy of its vaccination program. Second, India’s disproportionate decline in growth relative to EMDEs, with the economy contracting by 8% in real terms in 2020-2021. The Indian economy has now returned, in real terms, to what it was in 2017-18. This is in addition to serial growth declines year-over-year from 2016-17. Third, there are strong headwinds on the path to economic recovery due to India’s failing banking system. Fourth, both exports and private investment show a long-term downward trend. Fifth, even though India’s budget deficit is above the EMDE average, there are headwinds on the path to fiscal correction as its tax-to-GDP ratio tends to decline, indicating a tax system. failing.

For all these reasons, India is particularly vulnerable to the external shock of a rise in US interest rates and a turnaround in the global financial cycle. The country’s macroeconomic fundamentals do not look good compared to its EMDE peers. It is also much more exposed than the rest of Asian EMDEs. India would do well to beware.

Alok Sheel is RBI Professor of Macroeconomics, Indian Council for International Economic Relations Research

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