Fed Tapering and the Indian Currency Crisis

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As the U.S. Federal Reserve gets ready to start tapering its quantitative easing program, it might want to pay close attention to the currency crisis now underway in India. For India's currency crisis is indicative of yet another major emerging market economy, along with Brazil, China, and Russia, that is already slowing markedly and that is likely to continue to slow in the months ahead. This should be of particular concern to the Federal Reserve since over the past three years the major emerging market economies have accounted for over 50 percent of global economic growth.

Over the past six weeks alone the Indian rupee has plunged by over 14 percent bringing its total decline over the past two years to almost 30 percent. Part of this decline is to be explained by a widening in India's external current account deficit to almost 5 percent of GDP. However, the more important source of foreign exchange pressure is coming from outward capital flows by both domestic residents and foreigners, who are becoming increasingly reluctant to finance India's external account imbalances at a time that the country's economic reform effort has stalled. As a result, economic growth, which had averaged around 8 percent in the decade prior to 2009, has now slumped to barely 5 percent. At the same time, led by rising import prices, consumer price inflation has risen to almost 10 percent.

True to form, the Indian government has responded to the foreign exchange crisis with a piecemeal approach that has been addressing the symptoms rather than the underlying causes of the crisis. Among the measures adopted have been increased tariffs and tighter restrictions on gold imports as well very much tighter restrictions on corporate and household capital outflows.

Little wonder then that, despite these measures, the Indian rupee keeps depreciating in the market to record low levels. It does so for want of a coherent plan to boost investor confidence to stabilize the currency as well as for fear that further capital controls will soon be introduced. It also does so for lack of any serious indication on the part of the Indian government that it is prepared to raise interest rates in defense of the currency and more important yet that it is ready to take measures to redress the country's basic savings and investment imbalance.

By now it should be clear to Indian policymakers that the foreign exchange crisis needs to be addressed by a basic shift in the overall macroeconomic policy approach aimed at restoring domestic and foreign investor confidence in the Indian economic growth model. It should also be clear by now that India does not have the luxury of waiting till after the scheduled May 2014 parliamentary elections to implement such a shift. This would seem to be particularly the case in the context of the tighter global liquidity conditions that might be expected once the US Federal Reserve starts to taper its quantitative easing program. For in the absence of an early restoration of investor confidence, India's currency could go into a real tailspin. Such an eventuality would leave the Indian central bank with little alternative but to hike interest rates to levels that could have untoward consequences for India's highly indebted corporate sector.

At the heart of any strategy to demonstrate to investors that India was serious about getting the country back on a rapid economic growth path would be a redoubled effort to restore momentum to the country's stalled structural reform program and to reduce the public sector budget deficit. In particular, bold steps should be taken to move the pricing and allocation of energy and food resources to a market basis that would improve both transparency and efficiency. In addition, every effort should be made to minimize the many structural roadblocks to investment as well as to improve the functioning of the labor market.

Sadly, ahead of India's May 2014 elections, there is little realistic prospect that India will take the bold economic measures needed to defuse the country's currency crisis since India's politicians will be loath to introduce painful economic reforms that might lose them votes at the polls. This makes it all too likely that the Indian economy will slow further over the months ahead as domestic interest rates will have to be hiked in an attempt to stabilize a weakening currency. It also makes it all too likely that India will only aggravate the more generalized economic slowing in the major emerging market economies. This will make for a very much less propitious international economic environment than desired for the Federal Reserve to start tapering its quantitative easing program.

Desmond Lachman is a resident fellow at the American Enterprise Institute. 

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