2020 was an unprecedented year as the global economy faced one of the worst health and economic crises. Governments and Central Banks across the globe came up with various measures to support the ailing economies. In this background, Central Bank including Federal Reserve slashed interest rate to near zero percent and announced Unconventional Monetary Policy (UMP) measures including Quantitative Easing to support their respective domestic economies. However, the impact of these measures was not confined to their respective economies but had spillover effects to other economies, especially the emerging markets.
The cheap credit from the developed economies fled to emerging markets in search of better returns. India also witnessed a huge surge in capital inflows during this period. From being the net sellers in the Indian market at $15 billion in March 2020, the net investment by FIIs/FPIs stood at $9 billion in December 2020.
Though the Indian economy benefitted from the capital inflows, any change in monetary policy stance by the Federal Reserve can hurt emerging economies including India. Federal Reserve is mandated to seek both full employment and price stability. Inflation was considered to be a dead phenomenon in the US as the inflation rate was running below the target of 2 percent. However, the US economy is now showing signs of heating up. For instance, in May 2021, consumer price inflation excluding food and fuel reached 3.8 percent, the highest in the last 29 years. Initially, the rise in prices was considered to be transitory. However, as the inflation figures turned out to be unexpected, Fed was forced to act and hinted at a rate hike of 50 bps by 2023. And, if the inflation rate continues to stay in the uncomfortable range, Fed will be forced to act even before 2023.
In such scenario, one could witness the reverse flow of funds from the emerging markets. FIIs/FPIs would prefer investing in the US as the emerging markets won't look lucrative in terms of returns. Indian economy passed through a similar episode in 2013, the infamous 'Taper Tantrum' Emerging markets found it difficult to digest the news of interest rate hikes by the US Fed. India was also not immune to it. We were one among the 'Fragile Five' economies, alongside Brazil, South Africa, Indonesia and Turkey. The hint of a rate hike by the then-Fed Chairman Ben Bernanke led to the reverse flow of capital from emerging economies to the US. It resulted a panic in the stock market and also witnessed major currencies depreciating against the US dollar. A depreciating rupee could make the imports costlier, and widen the trade deficit if the exports didn't catch up.
Presently, India's forex reserve is in a comfortable position at $605 billion (as on June 4, 2021). Yet, the RBI should be prepared to deal with the volatility arising, if there is a reverse flow of funds to the US.
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