Fed won't taper QE unless jobs spurt: Morgan Stanley

At a time when most institutional investors are critically reading the minutes of the Federal Open Market Committee meeting, Manoj Pradhan, global emerging markets economist, Morgan Stanley believes the Fed will taper the quantitative easing (QE) later than what the markets are factoring.

Pradhan's views come on a day when the US market ended in red due to the uncertainity of Fed’s QE program. Most analysts expect the Fed to continue its monetary stimulus program infusing liquidity in the markets but Fed’s Chairman, Ben Bernanke hinted at a tapering off in the QE based on the macro economic data.

"The markets are talking about tapering off the latest edition of QE starting sometime in September. We think it is more likely to happen in December. So, the tapering off the stimulus now will start much later or atleast a few months later than what the markets think," adds Pradhan in an interview to CNBC-TV18.

Pradhan adds that the Fed would like to see sustained employment numbers, more likely in the range of 175,000-200,000, before easing its QE. However, media reports expect jobs growth to be around 170,000 in May itself while it grew only to 165,000 in April. Media polls see the umemployment rate for May at 7.5 percent vis a vis 6.5 percent that the Fed is targeting.

Below is the edited transcript of Pradhan's interview to CNBC-TV18.

Q: Whether or not the Fed is actually going to rollback stimuli? What is Morgan Stanley factoring in at this point in time, i.e. what is the likelihood of a rollback of QE from the Fed and by when if in case that is the scenario? A: The Fed at some point has to withdraw stimulus. It cannot remain where it is for a very long period of time. What that period means is what is more important. Fed Chairman, Ben Bernanke said that they need to see a sustained improvement in the labour market. That means a set of sustained payroll numbers that are in the 175,000-200,000 range. If that happens for a few months, then the Fed will start thinking about it. The markets are talking about tapering off the latest edition of QE starting sometime in September. We think it is more likely to happen in December. So, the tapering off the stimulus now will start much later or atleast a few months later than markets think.

The sequence of events is that right now they have an open-ended stimulus package in place. They will start talking about tapering that stimulus off which is what is happening now. The Fed will then actually taper it, followed by stopping that stimuli, take a pause, and then talk about withdrawing from QE to finally make an exit. So, the sequence of events is drawn out. It could take a couple of years for that whole story to go through.

Q: If and when that is the case i.e. Fed does withdraw QE what is the risk that Emerging Markets (EM) especially something like India run in terms of flows?
A: Capital flows to emerging markets (EMs) in general are a very mixed animal these days. We cannot say that any one thing will lead to capital outflows or lead to capital reallocation.
Part of the reason that capital is slow into EMs is because large players in developed markets like pension funds and large institutional investors have been under-allocated to EMs which is why for portfolio reasons they have diversified some of the capital that they deploy into EMs.
These are structural flows. These are not as easy to move back. The concern being raised is more of a macroeconomic concern that if the Fed exits from QE or any kind of increase in real interest rates hits EMs at a time where they still have a fair bit of financing to do.
It is an issue similar to India's current account deficit (CAD), but similar situations matter for Turkey and South Africa. When one starts seeing an exogenous tightening imposed by a Fed exit on EMs, what is important to note is if emerging markets have the stability to maintain their macroeconomic performance and if not, then what will be the reaction of portfolios. That is the more interesting and important question.
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There will always be a kneejerk reaction. For example, if the commodity market turns up sharply tomorrow one will see a kneejerk reaction that will take capital out of large commodity importers and India would be one of those. It is more meaningful to talk about what removal of stimulus will mean for macroeconomic conditions and hence for capital flows. Looking directly to capital flows gives a misleading picture of how institutional investors are thinking.

Q: We have seen near-term depreciation on the rupee. Is it entirely a global dollar strength story or do you think there are key risks in India to the downside?
A: The initial phase for the rupee’s downside was certainly dollar appreciation. We have seen stronger numbers come out of the US economy which is why the whole point of Fed tapering off QE3 purchases is here. If the economy was not in shape for the Fed to even think about tapering off its policies, then we would not have dollar strength quite the way we have seen it.
However, the second part of the story has been EM weakness. The countries that have suffered more than the others are the ones where one starts wondering what the impact of real rates and what the change in financing conditions will be. We are too early to think about it. This was a dress rehearsal or a wake up call for economies to get their act together to make sure that their financial conditions are easier to meet in the future. I think it has been a scare more than anything else, but the countries that have been affected more are the ones whose financing conditions are being seen as markets as not very solid and that is something that countries like India, Turkey and South Africa have to consider. Q: We have had some fairly dismal growth numbers for FY13. What are your thoughts on how India is placed versus other EMs in FY14 growth?
A: India's growth story is something that my colleague Chetan Ahya sees improving only very slowly over a period of time. We have got all these cyclical drags which are hemming us in as far as growth is concerned. From my point of view that has been one of the catalysts for structural reforms.
The mismatch that is happening in India is that the Indian administration is being forced to use structural reforms to address what is a very, very deep cyclical problem, but it is much better than going the other way around.
Countries like Brazil have used cyclical tools to try and deal with the structural problem which never yields results which is why the Indian strategy has a positive outlook. If implementation takes place on those structural reforms and the pace of structural reforms is kept up, because it can deliver not only some relief from cyclical growth much further down the line, but also bolster medium-term trend growth. That, really is the key outlook which differentiates India from a lot of other EMs.
The other EM that is running exactly the kind of structural reforms that are needed, is Mexico, but the difference is Mexico is running those reforms out of a position of strength. Their own domestic condition has improved, the US economy is doing well. However, India is running those structural reforms from a position of weakness. So, in a very counterintuitive sense the weakness in the domestic economy actually reinforces the need for those structural reforms and makes them more feasible.
Clearly India's exports are about 20 percent as far as the spending impact is concerned and any slowdown anywhere in the world will have an impact on decisions of the corporate sector here. What is important to keep in mind is that the trajectory for the US economy is actually fairly decent. Below that fiscal drag that one has seen slowing down growth in the first quarter, the private sector is resilient, households and corporates have done decently well. Banks have been lending money, not in large amounts, but they have been lending money for quite some period of time to Commercial and Industrial (C&I) borrowers. Also, I think there are some positive signs that the second half of the year will be better even in Europe, and certainly in the US economy. One is already seeing better numbers coming through in Japan.