By the early hours of Friday morning, we will come to know whether the United States Federal Reserve has lifted off from its near-zero interest rates of the last several years, or not. If it does, then this will be the start of one of the most important regime shifts in global financial conditions in a long time. It would be a mistake to underestimate its impact on emerging market (EM) economies, including India.
By itself, the act of raising the policy interest rate from the current near-zero level is unlikely to be problematic, even though a vast swathe of the global market expects the Fed to delay the hike. Indeed, one could well see the market heave a collective sigh of relief as a major global uncertainty is resolved, and because the rate hike is likely to be accompanied by an assurance from the Fed that the normalisation would be a deliberately slow process. By starting now, the commitment of the Fed to move gradually would become that much more credible. But beyond that, it does not really matter much if the timing of the initial rate hike is shifted around by a few months.
Far more important is whether the Fed will have the luxury of delivering on its promised gradual normalisation. Central to such a commitment is the Fed’s belief that the potential (capacity) growth rate of the US economy is 2.2 per cent. To achieve this capacity growth rate, US labour productivity has to surge in the coming years from the subdued levels of the last four years. If productivity rises only modestly, as looks likely in the absence of major technological breakthroughs or structural reform, then potential growth could fall well short of the 2.2 per cent mark. In this case, even with moderate GDP growth, the excess capacity could disappear much more quickly than expected, pushing up costs, particularly wages. With the economy reaching the inflection point in wages earlier than expected, the Fed could be forced to tighten more aggressively, resulting in a sharp realignment in US interest rates. Admittedly, this is not an immediate risk, but a couple of sharp spikes in wages and the market will bring forward the realignment. That would be a major jolt to global financial conditions, hurting all EM economies, including India, perhaps quite severely.
Put differently, even if one uncertainty is resolved this week, another would remain for some time to come. Can countries like India defend against such a shock? Much has been made of the $355 billion foreign reserves of India, but even China’s mammoth war chest of over $3.5 trillion in reserves isn’t an effective deterrent, as recent events have shown. Thus, India will need to be prepared to lose substantial reserves if it plans to defend the rupee through foreign exchange interventions. The alternative is to match the rise in US interest rates by raising domestic interest rates — a possibility that is not even on the radar of either the market or India’s policymakers.
Adding to the uncertainty is the slowdown in China and the attendant adverse impact on global demand. We seem to be taking solace from the fact that India’s small direct export exposure provides protection from being hurt by the decline in Chinese growth, forgetting that more than 25 per cent of the country’s exports are destined for commodity-exporting countries (West Asia, Russia and Latin America), all of which have been severely affected by the China slowdown. When the world’s second largest growth engine stalls, it is a mistake to believe that, in this interconnected world, India will somehow come out unscathed — and so far, export data suggests that it hasn’t.
Related to the slowdown in China is the decline in commodity prices which, in the case of oil, has been complemented by a rise in global supply following the thawing of the trade embargo on Iran. This, on paper, should have been an unambiguous positive for commodity-importing countries like India, thanks to declining inflation boosting household real incomes and falling input costs raising corporate margins. Yet, neither corporate investment nor household consumption has increased commensurate to the massive fall in oil and other commodity prices. Instead, both corporations and households have increased their savings (as reflected in the decline in India’s current account deficit); a reaction more consistent with rising uncertainty than good fortune.
So what should policymakers do in such uncertain times? The prudent course would be to hunker down and preserve stability, awaiting greater clarity. rather than turn to policy adventurism. With the sharp decline in India’s inflation, the pressure is on for interest rates to be cut further. The argument is that this would boost both consumption and investment. But money is fungible.
The government can easily deliver the equivalent of several percentage points of rate cuts by passing on the decline in global crude to retail pump prices rather than taxing most of it away, as it has so far. This would be the safer option. Cutting domestic rates in the face of Fed tightening unnecessarily raises India’s external vulnerability. More importantly, if the already outsized decline in inflation and input costs hasn’t induced either households or corporations to raise consumption or investment, would a few more basis points of interest rate reduction or its equivalent change anything much?
The global economy has been undergoing multiple structural changes since the 2008 crisis, including unorthodox policy experiments. Many of these changes haven’t fully run their course. Policy mistakes now could turn out to be costly later. Hunkering down as a strategy is neither clever nor exciting, but it just may be the right thing to do today.
The writer is chief Asia economist, J.P. Morgan Chase. Views are personal.