A taper tantrum around 2024 polls could be Modi govt’s biggest economic trial
When the Indian economy contracted by 23.9% in the quarter ending June 2020—the biggest contraction among major economies—everyone feared an unprecedented economic crisis. To be sure, matters are still grim, and India’s GDP will face its biggest ever contraction in 2020-21. But the economy came out of the contraction zone in the December quarter with a growth rate of 0.4%. Almost all forecasts now predict a smaller contraction in 2020-21 and higher growth in 2021-22 than they had projected a few months ago.
Some independent economists maintain that the nature of recovery in the economy has not been equitable. There is evidence to suggest that while the relatively rich, both firms and individuals, have been spared the worst effect, perhaps even added to their wealth and profits, the not so well-off have suffered a dent in incomes and bargaining power. Lack of comprehensive empirical evidence makes it difficult to predict the effects of the pandemic’s asymmetric impact on the rich and non-rich on future growth as well as politics.
While most of the economic analysis around the pandemic’s impact on the Indian economy has focused on domestic factors, there is merit in looking at the impact of a near-certain economic disruption to the Indian economy in the next few years. This will arise when central banks in developed countries, especially the US Federal Reserve, raise interest rates as their economies recover from the impact of the pandemic and inflation begins to gain momentum. Such a move is likely to create a taper tantrum-type situation, much like the one India faced in 2013, and could inflict a serious blow to the economy. Because it will most likely coincide with the 2024 elections, the political economy challenge could be bigger.
A taper tantrum refers to the 2013 rise in US Treasury bond yields that resulted from the Federal Reserve announcing it would taper the pace of its purchase of Treasury bonds, to reduce the amount of money it was feeding into the economy.
Inflation and interest rates in the US are still low, but that might change
Both inflation and interest rates fell sharply in the US after the pandemic. According to the Organisation for Economic Co-operation and Development (OECD) database, long-term interest rates—those on 10-year treasuries—in the US came down from 1.5% in February 2020 to as low as 0.62% in July 2020. While it has increased to 1.08% by January, this is still significantly lower than the 1.76% it was at in January 2020. Inflation too fell sharply. It was 2.33% in February 2020 and fell to 0.11% by May. This has increased to 1.39% by January 2021. Historically, these numbers are still on the lower side but they seem to have started gaining momentum. With the Biden administration planning to give another fiscal stimulus and the federal reserve announcing that it will not increase interest rates lest the economic recovery is jeopardised, inflation could increase going forward.
V Anantha Nageswaran, a member of the Prime Minister’s Economic Advisory Council, articulated this view in his latest Mint column. “Well, rising commodity prices, increasing unit labour costs, fiscal expansion and its accommodation by central banks appear to be the perfect combination for return of inflation. That is one of the reasons behind the sharp rise in the yield on the 10-year (US) bond from a low of 0.54% in March 2020 to 1.38%,” he wrote on February 23. To be sure, there is nothing to suggest that we are going to have an immediate inflationary upsurge; prices of commodities are still not at very high levels.
A Bloomberg opinion piece by Bill Dudley echoed the same opinion in greater detail. Dudley has laid out a three-stage cycle for the coming inflation cycle. Stage one will be driven by a base effect of low inflation last year and pent-up demand for services, which he argues will be ignored by the Fed. Stage two will see the US economy making a recovery to full employment levels, helped by the coming fiscal stimulus, which might take a year or two. This, Dudley predicts, will lead to a halt on fresh liquidity infusion, but rates will still not rise. Stage three will come when the economy is at full employment and inflation climbs up to 2%, at which point interest rates will be raised and raised quickly. “Ultimately, the process should leave US interest rates higher than they’ve been in a long time. The bad news is that the transition will likely be painful for financial markets” Dudley said, which is the exactly what Nageswaran argued in his column.
“In short, while the fear of inflation is not ill-founded, it is still premature. What we have in plenty already is asset price inflation. The train had left the station long ago. Central Banks waved it off and are still waving it past. Once that train eventually stops, the effect will be deflation. Central banks will probably then go full Monty on Monetary policy and then we will have inflation,” he wrote.
What does all this mean for India?
As and when interest rates are raised in the US—other advanced countries will follow suit—a taper tantrum will play out, with capital from the non-advanced economies returning home as returns increase. Like the one in 2013, this will create significant disruption, especially in currency and capital markets. Interest rates might have to be raised as well, in order to prevent a large-scale capital flight. If the taper tantrum coincides with a phase when commodity prices, especially oil prices are at higher levels, this could also have an inflationary impact on the economy, as a weaker rupee increases energy import bills and higher interest rates generate overall tailwinds for inflation. A look at key economic indicators in India during the May 2013 taper tantrum shows that the rupee significantly lost its value, foreign exchange reserves went down temporarily, interest rates had to be increased and inflation went up, before it came down along with a fall in crude oil prices. The taper tantrum was just one of the shocks to the Indian economy in 2013, and many economists believe that the economy was already overheated thanks to the government’s delay in rolling back the fiscal stimulus after the 2008 Global Financial Crisis.
Fast forward to 2023-2024...
Just the fact that there might be a taper tantrum does not mean India will face a big macroeconomic crisis. After all, India’s foreign exchange reserves are significantly higher than what they were during the 2013 taper tantrum. This will give Reserve Bank of India more firepower to deal with such a disruption in currency markets. Foreign currency reserves cushion notwithstanding, there are reasons why the macroeconomic situation might be something to reckon with. Two factors could play an important role.
Indian households have a much bigger exposure to capital markets than earlier
While capital markets are volatile by nature, and their movements do not coincide with the real economy, there is one way in which they can affect consumption decisions: the wealth effect. When capital markets surge, investors experience a positive wealth shock, which has the potential to boost consumption. Similarly, a collapse in markets, even if temporary, can impart a negative wealth shock and generate headwinds for consumption. Exposure of households to capital markets in India has been increasing.
A large capital market correction, if it comes with the taper tantrum, perhaps even after that as Negeswaran warns in his column, will lead to a bigger consumption shock to the economy than last time. This, when read with the fact that the post-pandemic recovery is likely to be led by the rich, as the poor, both individuals and firms, have suffered greater scars, might pose bigger problems for the economy.
A fiscal/monetary tightening might not be in sync with the 2024 general elections
If interest rates in advanced countries start rising a couple of years from now, both fiscal and monetary policy in India will come under pressure. This year’s budget has projected that India’s fiscal deficit will fall to 4.5% by 2025. The government’s debt-GDP ratio is likely to remain at elevated levels in the medium term. While the government seems to be banking on a formal sector even profit-led recovery as of now, it would like to announce a welfare boost before the elections. This could include things such as a hike in PM-KISAN transfers. Unlike MGNREGS wages, these are not indexed for inflation currently. A macroeconomic disruption due to a taper tantrum could spoil these plans as loose fiscal/monetary policy might aggravate problems on the external front. The government will face an unenviable choice of placating international finance or its poor voters.
Matters could be even more difficult if the ongoing commodity price rally, especially in crude petroleum, and systemic inflationary drivers such as the extension of the Goods and Service Tax (GST) compensation cess period, as decided by the GST Council, keep inflation at elevated levels even before the taper tantrum’s shock. In that case, the government will be forced to reduce the existing duties on petrol-diesel, at the cost of ruining the fiscal. This, the oil-price challenge, will likely play out first.