T he week starting February 13 began with mayhem in India’s stock markets, with the Sensex falling by close to 1,750 points. While some analysts attributed the fall to the standoff between Russia and the North Atlantic Treaty Organisation over Ukraine, there are clearly longer-term issues involved—not the least of them is the 40-year high that inflation in the United States has touched, with the annual rate in excess of 7 per cent for two months running.
Foreign institutional investors, who have, over two decades, overwhelmingly determined the direction of the movement of stock prices in India and influenced the behaviour of domestic institutional and retail investors, are withdrawing from Indian markets. This is because, besides directly troubling financial investors by eroding the real value of financial assets, the high and even accelerating inflation rates in advanced economies are forcing Central banks to go back on the unconventional monetary policies—involving near-zero interest rates and massive liquidity injection—they have pursued for well over a decade now.
The Federal Reserve, for example, has decided to halt its “quantitative easing” programme under which it had bought large volumes of bonds every month from the market with the intent of pouring liquidity into the system. It has also signalled that it will resort to more than one significant increase in interest rates over the coming year.
End of the cheap money era
The adoption of a tighter monetary stance and higher interest rates will bring to an end the era of easy and cheap money which had fuelled asset price inflation in financial markets even when real economic growth remained subdued in the years following the 2008 crisis. The consequences are visible in advanced country bond markets, with a sell-out of two-year U.S. government bonds pushing yields to above 1.6 per cent, as compared with levels of just 0.4 per cent in November. The Standard & Poor’s 500 index for U.S. stocks is also down by more than 6 per cent in the first month-and-a-half of this year.
Inflation, and the monetary response to it, is also encouraging investors to pull back on investments in emerging markets and rebalance their global portfolios. The volatility in India’s stock markets is clearly driven by such actions and the knock-on effects they have on domestic investors. As the cost of capital rises and net returns are squeezed, carry trades—or the practice of taking on cheap dollar debt to invest in emerging markets where returns are high—seem less attractive. And with the likelihood of depreciation of currencies in emerging market currencies in the current environment, the risks associated with such investments are rising.
The problem is that the disruption in markets will, in all probability, only intensify. This is because the uncertainties and downside risks in developed-country markets, from where the destabilising winds blow into emerging markets like India, are substantial and not even fully understood. To start with, while there is agreement that the unwinding of unconventional monetary policies will disrupt markets, there is lack of clarity on how severe, widespread and long-lasting that impact would be.
But there is a growing realisation that markets have for too long been provided loads of cheap money that financed speculative investments and inflated prices in asset markets. Asset prices may have risen partly because some investors were convinced that corporate profits that ruled high, facilitated by state policy, would remain high for quite some time into the future. But the main reason was that most investors believed that interest rates would remain low and liquidity would be abundant, and that, like them, many others would borrow and invest to keep markets buoyant and rewarding.
As it becomes clear that such belief is unwarranted, markets are bound to unwind dramatically with ripple effects that can be quite damaging. It was this fear that kept unconventional monetary policies in place for long. The pandemic and the periodic halts in economic activity that accompanied it provided additional reasons for extending that regime. How much that has inflated markets beyond levels from which they can be safely unwound is unknown, adding to the uncertainties that threaten to roil markets.
Since the early 1980s, advanced economies, especially the U.S., have been through the period identified as the Great Moderation when inflation was consistently low. This lulled policymakers into believing that capitalism had put behind it the Great Inflation, seen in the years between 1965 and 1980. As a result, the current inflation, which was initially expected to be transitory, is not seen as long-lasting, and is attributed to likely-to-be-short-lived “exogenous” factors such as rising oil and commodity prices rather than the inner dynamics of capitalist societies. So, risking some inflation, over not too long a period, appears to many policymakers as a better bet than embracing the dangers potentially associated with the unwinding of cheap money policies.
This results in much uncertainty about how soon and how far the Fed for example, would go in unwinding its unconventional monetary stance. But the proclivity to postpone coming to terms with inflation delays and prolongs the portfolio adjustment needed to facilitate a soft landing. It will also force Central banks to tighten monetary policy much more sharply in the coming months with potential unintended consequences.
It is precisely when inflation is rearing its head that developed-country governments, rudely awakened by Chinese competition and the COVID pandemic, are coming to terms with the consequences of the conservatism that characterised their fiscal policies for the last four decades. In the U.S., this has meant that under the Joe Biden administration, federal spending is being hiked hugely, even if not to the extent that the Democrats would have liked. Although this is the way to go with large unutilised capacities in most economies, markets are overcome with the fear that such spending will only worsen the inflationary spiral and its consequences for market “performance”. Repeated references to supply-side bottlenecks and supply chain disruptions reflect the fear that increases in demand driven by enhanced state spending will run into a wall and drive up prices.Finally, U.S. growth, however strong it may or may not have been, has ridden on financial bubbles, with asset price increases and easy credit encouraging consumption. Now, growth has slowed for a host of reasons. If the financial buoyancy that breeds confidence and encourages consumption were also to give way, a recession could accompany a financial meltdown.
Trouble for India
These uncertainties are bound to make the adjustment that is inevitable also unpredictable in terms of nature and intensity. This can spell trouble for emerging markets such as India. Foreign financial investors are likely to book profits and exit either because of rising capital costs or the need to cover losses at home. Domestic financial investors who were attracted by the returns ensured by foreign financial flows into shallow and thin markets, where stocks of a few firms are actively traded and the share of free floating stocks of those firms available for trading are also limited, will retreat. This will intensify market turmoil and foreign capital exit.
But this is perhaps not the main threat. That will come from the impact that the exit of foreign capital will have on the exchange rate. During the taper tantrum of 2013, the rupee came under pressure soon after the then Federal Reserve Chair Ben Bernanke announced that the central bank was contemplating tapering out its bond purchases. That finally did not happen, and the Reserve Bank of India managed, through unconventional means, to stabilise the rupee. If there is an actual exit of capital, that may be difficult to ensure, and it can lead to other repercussions.
During the years of cheap money, when interest rates abroad ruled much below domestic rates in India, many corporate groups borrowed heavily in global markets. If the rupee depreciates, the rupee cost of servicing that foreign debt can spike, eroding profits and damaging balance sheets of domestic firms, and even triggering bankruptcy. How far this will go is unclear, since there is so much that is not known about the way the global economy will unwind.
The current and past governments that ruled India cannot absolve themselves of responsibility of whatever ensues by attributing those outcomes to external forces outside the control of the domestic state. If India is vulnerable to developments abroad, it is because these government have, by opting for financial liberalisation and openness, integrated domestic and foreign markets. The presumption implicit in that choice of policy regime is that the government has in its hands instruments with which it can either moderate exposure to volatilities transmitted from abroad or manage the consequence of such volatility. Neither of that is necessarily true.
