Competitive Monetary Expansion and Currency Devaluation - Assignment Example

Macro and Micro Economics of the of the Contents Contents 2 Summary 3 This report foregrounds the impact on India in greater details. 3 Economic Rationale behind These Policies 3 Reasons of Pressure 7 Potential Risks and Costs 9 Effectiveness of the Policies 10 Potential Actions 11 The Indian government is trying to improve the state of capital inflows by way of issuing quasi-sovereign bonds to fund projects on infrastructure. The nationally owned oil companies are also trying to raise fund by trade finance and external commercial borrowings. It is expected that capital inflows to the country would improve on account of adaptation of these measures (Ministry of Finance, 2013). 13 Recommendation 13 Considering the crisis at hand, few recommendations can be suggested for the government of India in order to improve its position in long run, if the Fed commences with the policy of tapering. It is important for the Indian economy to stabilize its currency in the long run to remain attractive for foreign investments. This can be achieved by direct intervention of Central Bank in the Forex market. Other efforts to stabilize the currency include liberalization of the interest rates and limiting intra-day limit of foreign dealers. Another way to boost the economy is to improve trade balance. This can be done by raising subvention for small and medium term exporters to increase the level of exports. Use of hedging strategies on part of the importers and exporters could minimize losses arising from the exchange rate. Also in respect to the Indian market, it has been observed that the depreciation of rupee has not been passed on to consumers, as majority of the items like, cooking gas, kerosene and fertilizer, are subsidized. Hence, removal of subsidies will help the government to pass the costs to people in order to discourage imports of these items. The fiscal deficit of the government is likely to reduce if higher price of energy is passed onto consumers, thereby bringing down the prices for energy imports. Finally, the government can create favorable environment in the country for the purpose of attracting FDI. FDI has been identified as a credential source of funding for most emerging countries like, India and China. Therefore, proactive liberalization of FDI in the Indian economy will be helpful in attracting investors. Enhancing freer investment in sectors, such as, retail, can help to draw in fresh investments in the economy. 13 References 14 Summary Tapering monetary policy adopted by many developed nations is putting pressure on the emerging countries. On December 2013, the Federal Reserve Bank of the U.S.A. announced that it would begin to lower bond purchases by $10 million on a monthly basis. Since announcement of this news, the emerging economies began to feel weight of the probable consequences of this action. Possible issues faced by these countries include more volatile currency fluctuations and excessive capital outflow. For example, both Turkey and South Africa experienced 6% and 7.5% depreciation respectively. The Governor of Central Bank of India, Mr. Rajan, has stated that such policies adopted by Fed are not only a threat for sustainable economic development, but also poses long-term financial risk to the global economy. While the U.S.A. argues that such policies have the capacity to augment demands in developing countries, a majority of rating agencies such as, S&P and Fitch, reckon that the emerging economies would almost certainly encounter unusual instability due to such an action (Live Mint, 2014). This report foregrounds the impact on India in greater details. Economic Rationale behind These Policies Central Banking authorities of the U.S., the U.K. and Japan have implemented unconventional monetary policies for reviving their economies from the state of recession caused during the global financial crisis. Irrational market exuberances and speculative trading activities within the real estate sector caused the global financial crisis in 2008. Through unconventional monetary policies, the Central Banks of advanced economies were able to ease their monetary conditions. By lowering the rate of interest, monetary authorities of these nations reduced the cost of borrowing money. This helped to stimulate the investment thresholds in these economies. Due to higher investments, the aggregate production activities had substantially enhanced in the U.S. This improvement helped to increase employment opportunities in the country. Higher employment opportunities stimulated the gross per capita income levels of individuals in the country, thereby reviving the downtrodden state of the market due to recession (Puskorius, 2014). It is found that even before recession, the economy of the U.S. had faced high budget deficit in international trade. The currency value of the country is high compared to several major economies. As a result, exports of the U.S. are expensive for the international market, but its imports from other economies such as China and Brazil, are quite cheaper (Puskorius, 2014). Moreover, income elasticity of the U.S. import possesses a higher value than income elasticity of its exports. All such factors have heightened value of the country’s imports relative to exports, thereby creating trade deficit. During recession, due to scarcity of money, the aggregate exporting capability of the U.S. economy had worsened, which in turn increased trade deficit to a greater extent. After implementation of the unconventional monetary policy (Quantitative Easing), currency value of the U.S.A. had devaluated. In this manner, demand for its exports in the international market had increased and that of imports had declined. All these factors have helped to lower the extent of trade deficit of U.S.A., post the recession (Puskorius, 2014). Following Quantitative Easing (QE), the U.S. economy has shown positive signs of recovery. The economic rationale behind following this tapering policy is to prevent the economy from overheating. The marginal benefits obtained from QE had begun to diminish. The Fed argued that when economic expansion is strong, underutilized resources are put back to work and then it is no longer necessary to keep the monetary policy expansionary. The economy of the U.S.A. had suffered a fall in the unemployment rates since its initial quantitative easing. Figure 1. Unemployment in the USA 2013-2014. Retrieved from http://www.tradingeconomics.com/united-states/inflation-cpi. The above graph clearly shows that unemployment rates in the U.S.A. have experienced a consistent fall from the previous financial year. Figure 2. Overall unemployment in the USA since 2008. Retrieved from http://www.tradingeconomics.com/united-states/inflation-cpi. The year immediately following the financial crisis was marked with a high level of unemployment, which had began to decline from the end of 2010. The second reason for tapering the monetary policy is that country’s GDP growth rate has almost returned to pre-recession levels, thereby eliminating any need to follow an expansionary monetary policy. Figure 3. GDP growth rate of the USA 2004-2014. Retrieved from http://www.tradingeconomics.com/united-states/inflation-cpi. The blue line records positive growth and the yellow lines show a negative rate of growth. It is clear from the graph that average growth from 2004-2008 is almost equivalent to that in 2011-2014 (I would switch the order between 2004-2008 and 2011-2014). Regarding inflation, however, similar trends were not observed, as the government has been unable to bring down the recession below 2% and it is unlikely to happen until end of 2015. Additionally, the Federal Reserve has found out that benefits that could be accrued from QE were no longer substantial as marginal efficacy of the bond purchases reflected signs of fading. Strong recovery of the labor market was evident from the falling rates of unemployment, which had also rendered the economic outlook stronger. As a result, need of QE becomes redundant. The interest rate is expected to rise from following this policy as rise in supply of bonds reduces their prices. As a result of this phenomenon, foreign investors show interest in purchasing bonds and price of the domestic currency value appreciates (Puskorius, 2014). Reasons of Pressure There are a number of reasons for which tapering policy followed by the Fed can cause pressure on an emerging country such as India. Indian capital market faces fear that foreign investment can be weakened due to the tapering. Among other countries in the Asian market, India was severely hit by the US monetary policy as India heavily relied on the foreign institutional investment. The liquidity of the economy is expected to dry up and interest rates (be specific). Since declaration of the event in May in the U.S.A., FII flown out from India has been estimated as 230 billion rupees (DBFS Research, 2013). The anticipation of tapering in the U.S. A. market has caused increased outflows of capital from both the bond equity markets. India had remained one of major beneficiaries of QE program undertaken in the U.S. A. and had helped the economy to gain capital inflows as high as $88 billion. The country’s bond market has shown extreme volatility since the declaration in May. The FII investment was valued at $30 billion and the month of June had alone experienced an outflow of $10 billion. The resulting fall in rupee from these activities is weakening corporate environment in the Indian market. Figure 4. Fluctuations of Indian rupee 2012-2013. Retrieved from http://finance.yahoo.com/news/Fed taper-indian-rupee-could-210008704.html. The above graph shows fluctuations in Indian Rupee in the past year. It can be clearly observed from the graph that the currency value has notably heightened since June after the policy of tapering had been announced by the Fed. Similarly, inflation rate in the Indian economy has also increased compared to previous financial year, which negatively impacts the nation’s economic growth. Figure 5. Inflation in India. Retrieved from http://finance.yahoo.com/news/Fed taper-indian-rupee-could-210008704.html. The current account deficit of the economy has, however, shown some signs of improvement in the past one year. One plausible explanation for this is a decline in trade deficit on account of greater fall in import compared to the export. Figure 6. Current account deficit India. Retrieved from http://finance.yahoo.com/news/Fed taper-indian-rupee-could-210008704.html. One economic rationale behind these adverse effects can be explained on the basis of simple economic theory. This is likely to happen because profits earned by the foreign investors in India would fall as value of the dollar appreciates. Weakening currency in the country is generally coupled with increasing concern for inflation, thereby hampering economic growth. Another major concern for India is that its cost of borrowing increases and as the value of rupee continues to fall, overall economic growth slows down. The reason for the outflow of foreign capital is that investors are unlikely to invest in a country with unstable currency. Exchange rate volatility risk is usually avoided by investors and they tend to invest in more stable economies. One rationale behind inflation is that imports become expensive, after the currency’s deprecation. The import cost drives the rate of inflation higher. Potential Risks and Costs The impacts of the policies adopted by Fed are anticipated to remain strong for the Indian economy due to spillover effects. The Reserve Bank of India has clearly specified that the global economy will be in disequilibrium if Central Banks of the developed countries like, the U.S.A. and Europe, do not internalize the impact of their tapering policy. The Indian investors would lose money if the Fed decides to move further with quantitative easing. If there is very high outflow of FIIs from India, then stock market of the economy will probably crash. The dollar value appreciation is likely to render investment in the U.S.A. more lucrative (Arora, 2014). Secondly, if value of the rupee depreciates further in the future, then current account deficit of the economy will invariably widen. Though a rising current account deficit in short run can be beneficial for the economy, the scenario would reverse in long run. The bonds issued by Indian government will lose its value, which in turn is likely to raise the yield. The result is a further weakened national currency. Rising current account deficit in the future is likely to let outflow of dollar from India and aggravation of this situation can lead to draining foreign reserves from the country. Under such a condition, foreign direct investment inflow to the country can help to improve the situation. This however will be unlikely as the U.S. market remains more attractive for the investors (Murthy & Das, 2014). Thirdly, the value of crude oil is expected to increase. The higher oil price implies higher food price level. This happens because the cost of transportation increases as the fuel cost rises Surging food prices in the economy has adverse impacts on the economy as thousands of Indian households are likely to be affected. The majority of low income families in a country like India are likely to be impacted severely if this situation arises (Majumdar, 2014). Finally, though traditional theory of trade states that depreciation of the domestic currency rupee will boost the export which in turn can drive higher growth. However, this benefit is not likely to be realized when the cost of inputs and raw materials rise. One such concerning factor is the higher oil price. Despite higher demand in the U.S.A. market, Indian exporters will not be able to take advantage of the higher demand if the cost of production in increases (Majumdar, 2014). Effectiveness of the Policies If the Federal Reserve decides to move forward with its policy of tapering Quantitative easing, complicated short and long run impacts are to occur. Impact to the Indian economy from the tapering policies is going to be lesser in short run compared to that in long run. This can be primarily attributed to the fact that India is considered as a net importer of global commodities, so trade balance of the economy is expected to improve. This would happen because trade imbalances of the country are likely to be corrected. The exports of India will gain pace in short run as the demand from consumer markets in the U.S.A. rises. Nonetheless, these effects are anticipated to wear off in long run and issues discussed in the previous section will dominate the economic scenario, thereby eroding economic growth of India (Jongwanich & Kohpaiboon, 2013). In case of the U.S.A. too, the policy is likely to have different impacts in the long and short run. The rise in interest rate in long run depends on the investors’ expectations and actions. Higher anticipation on part of the investors will escalate the rate of interest faster. Even so, interest rates would remain unaltered in short run. The impact of quantitative easing on the U.S.A. market can affect three different interest rates, namely discount rate, Federal funds rate and long-term yields. If the Federal Reserve increases the discount rate, then commercial banks would possibly increase their rate of loans for customers in short run. The interest rate on mortgages as well as rate of borrowing will also rise. The Federal fund rate is expected to increase in short run as discount rate of the government increases. The rationale behind this is that excessive supply of bonds in market will reduce their price. Finally, regarding the effect on long-term interest rate, it can be stated that it will be slightly ambiguous. This is due to a number of other economic factors such as, inflation rate and level of private sector saving. On basis of the relationship between nominal GDP and bond yields, the 10 year bond yields are expected to rise by 3.5% (Garg & Dua, 2014). Potential Actions In the wake of the Fed announcement concerning tapering of Quantitative Easing, the Indian government has already responded with a series of actions. These include reduction of current account deficit and increment in the interest rates. The country has also begun to give higher effort to accumulate foreign reserves. Reserve Bank of the country has heightened the interest rate by 75 basis points, after announcement of Federal Reserve regarding the phased reduction in monetary policy. The primary effort is to control consumer price inflation in the economy. In order to improve the current account deficit, the Indian government is planning to reduce the import of gold and silver, crude oil and other imports that are less essential for the nation’s economy (Bloomberg, 2014). The Indian government is trying to improve the state of capital inflows by way of issuing quasi-sovereign bonds to fund projects on infrastructure. The nationally owned oil companies are also trying to raise fund by trade finance and external commercial borrowings. It is expected that capital inflows to the country would improve on account of adaptation of these measures (Ministry of Finance, 2013). Recommendation Considering the crisis at hand, few recommendations can be suggested for the government of India in order to improve its position in long run, if the Fed commences with the policy of tapering. It is important for the Indian economy to stabilize its currency in the long run to remain attractive for foreign investments. This can be achieved by direct intervention of Central Bank in the Forex market. Other efforts to stabilize the currency include liberalization of the interest rates and limiting intra-day limit of foreign dealers. Another way to boost the economy is to improve trade balance. This can be done by raising subvention for small and medium term exporters to increase the level of exports. Use of hedging strategies on part of the importers and exporters could minimize losses arising from the exchange rate. Also in respect to the Indian market, it has been observed that the depreciation of rupee has not been passed on to consumers, as majority of the items like, cooking gas, kerosene and fertilizer, are subsidized. Hence, removal of subsidies will help the government to pass the costs to people in order to discourage imports of these items. The fiscal deficit of the government is likely to reduce if higher price of energy is passed onto consumers, thereby bringing down the prices for energy imports. Finally, the government can create favorable environment in the country for the purpose of attracting FDI. FDI has been identified as a credential source of funding for most emerging countries like, India and China. Therefore, proactive liberalization of FDI in the Indian economy will be helpful in attracting investors. Enhancing freer investment in sectors, such as, retail, can help to draw in fresh investments in the economy. References Arora, K. (2014). Depreciation of Rupee. International Journal of Emerging Trends in Science and Technology, 1, 1-14. Bloomberg. (2014). IMF calls for Indian emergency rupee plan in taper warning. Retrieved from http://www.bloomberg.com/news/2014-02-20/imf-advises-india-to-ready-emergency-rupee-plan-in-taper-warning.html. Chen, X. Y. (2014). The Fed taper and Indian rupee could still hurt potash companies. Retrieved from http://finance.yahoo.com/news/Fed-taper-indian-rupee-could-210008704.html. DBFS Research. (2013). Fed tapering and its impact on Indian market. Retrieved from http://www.dbfsindia.com/downloads/research/daily/Fed180913.pdf. Garg, R. & Dua, P. (2014). Foreign Portfolio Investment Flows to India: Determinants and Analysis. World Development, 59, 16-28. Jongwanich, J. & Kohpaiboon, A. (2013). Capital flows and real exchange rates in emerging Asian countries. Journal of Asian Economics, 24, 138-146. Live Mint. (2014). S&P says Fed tapering may hit banks in emerging economies. Retrieved from http://www.livemint.com/Industry/9F0ULOGkyQDyP35xjhcB0H/SP-says-Fed-tapering-may-hit-banks-in-emerging-economies.html. Majumdar, R. (2014). Slower but still steady. Asia Pacific Economic Outlook, 5, 21-31. Ministry of Finance. (2013). Quarterly Review 2013-14. Department of Economic Affairs. Retrieved from http://www.finmin.nic.in/reports/QrtReview_june201314.pdf. Murthy, K. D. T. & Das, A. (2014). Rupee devaluation: Current perspective in Indian scenario. International Journal of Applied Financial Management Perspectives, 2(4), 628-632. Puskorius, V. (2014). The effect of U.S. monetary policy on emerging markets. Retrieved from http://globaledge.msu.edu/blog/post/2650/the-effect-of-u.s.-monetary-policy-on-emerging-markets. Trading Economics. (2014). Datafile. Retrieved from http://www.tradingeconomics.com/united-states/inflation-cpi. Read More