Emerging markets contagion: Inflation targeting reins in outflows

Indonesia last week surprised with a 50 basis points increase in interest rate to ward off an emerging markets currency sell-off, which came on top of two such raises in May. Investors are betting on more. In contrast, the Reserve Bank of India raised by a quarter point last month for the first time in more than four years. There’s little panic as of now — either in markets or in policy circles — despite a record low for the rupee.

What Made the Difference?
Prudence, it would seem. Indonesia cut interest rates eight times since 2016 to boost growth, which never materialised. Reserve Bank of India held on, drawing criticism for crippling growth. Governor Urjit Patel’s dismissal of a question on rupee slide without the customary cliché, “We don’t intervene to decide direction, but only look at volatility,” reflected a new chapter in currency management.


The rupee’s slide to a record low is pinching the pockets of importers and those who have borrowed in dollars. But not many are complaining like they did in 2013 or 1997. The rupee fell to a life-low of 69.09 to the US dollar last week. India’s macroeconomic numbers are worse than what they were two years ago. But dig a little deeper, and economists agree that other than better fiscal and current account positions than in 2013, inflation targeting is turning out to be the buffer against capital flight.

“Inflation targeting provides policy makers a much clearer framework within which they can formulate an appropriate policy response,’’ says Su Sian Lim, senior economist, A-Pac, BNP Paribas. “Consequently, global investors are able to rely on a greater degree of consistency and accountability with regards to these policy responses.’’ The rupee is down 8% to the dollar compared with the EM currency index, which is down 3.5%. Foreign fund outflows also have not been as strong as in 2013. Foreign funds have so far pulled out Rs 45,953 crore from India this year. In May-June, it was Rs 45,571 crore, compared with June-July 2013 pullout of Rs 62,286 crore.

The movement of currency is often an adjustment to the price differential between trading partners, which is why low inflation nations have a stable currency. The Monetary Policy Committee (MPC) entrusted with keeping consumer price index (CPI) at 4% has been unwavering. When, in June, MPC was expected to keep rate on hold, it raised it by a quarter point. Governor Patel’s message was, “We take care of inflation and that takes care of everything else.”

“Monetary policy is determined by our inflation targeting mandate and not by anything else,” Patel said. ‘If there are international financial or crude oil or commodity price developments, then it is internalised in inflation forecast projection and the consequent policy choice.’’

Current Account Curse
Current account deficit, excess of imports over exports, has been the root cause of India’s economic woes in the past. Crude oil and gold have been at the heart of it. Once again, crude is triggering a currency slide. The benchmark Brent has risen 93% from 2016 lows to $74 a barrel. “India’s macros have improved significantly, but the recent rise in oil prices has caused some stress, adding to multiple global risks, with consequent volatility in exchange rate markets shrinking carry trade driven portfolio flows,’’ says Saugata Bhattacharya, an economist at Axis Bank.

Every $10 a barrel increase in oil price would worsen current account by 0.4% of gross domestic product. It would push inflation 30-40 basis points, hurt growth 15 bps and worsen fiscal balance 0.1% of GDP, estimates Nomura Securities. A basis point is 0.01 percentage point. CAD, as percentage of GDP, which was 4.8% in 2012-13, fell to a low of 0.7% in 2016-17, thanks to drastic measures such as curbs on gold imports and subsequent inflation targeting. But that has started rising. It rose to 1.9% in 2017-18.

But there’s some relief on the gold front, with demand falling to 855 tonnes a year in 2017, from nearly 1,000 tonnes in 2010. But electronic items import is turning out to be a pain point. “Standard Chartered expects CAD to widen 2.5% of GDP this fiscal. “A mix of factors like higher crude oil prices, high electronic imports, normalising gold demand and improving domestic demand are set to widen CAD,’’ says Anubhuti Sahay, economist, StanChart.

Vanishing Carry Trade
Capital flows through foreign portfolio investors and other investments kept funding India’s thirst for imports. But the normalisation of monetary policy by the Federal Reserve and European Central Bank may reverse the flows. Simultaneous higher rates and lower liquidity when central banks sell bonds from their portfolio could amplify the capital flight as the so called carry trade - borrowing from low interest economies to invest in higher yielding assets - become unviable.

“Carry trades have definitely have witnessed a difficult time this year, amid the compression of differentials against dollar,’’ says BNP’s Su. “Asset prices in this region might not rise the way they used to when funding was cheaper.’’

Emerging markets which received huge flows between 2009 and 2017, is reversing. Withdrawals from the iShares MSCI Emerging Markets ETF exceeded $5 trillion in the second quarter, rivaling levels seen during euro-area debt crisis and the winding down of Federal Reserve stimulus in 2014, Bloomberg reported.

This fund pullout has led to violent movements in financial markets, with Argentina, Turkey and Malaysia bearing the brunt. Investing in Indonesian Rupiah denominated bonds at 7.7% or Indian bonds at 7.9 yields is no more lucrative, adjusted for currency movement. Even if portfolio flows resume, they may be in Argentina, Brazil or other EMs where assets are cheaper than in India.

In fact, China which is a current account surplus economy, but a fragile domestic debt scenario, is being whipsawed. Its Yuan is down 2.5 % this year and the Peoples Bank of China is talking up the currency. “The contagion started initially from Argentina, then Turkey, then Brazil, South Africa…. India was broadly moving in line with that and then it spread to Indonesia,’’ says Abheek Barua, economist at HDFC Bank. “There was a limited contagion among fragile emerging economies.’’ Flows turn violent in times of rate movement and the chained financial markets expose almost every country to volatility.

India is no exception. While India’s stand alone economic position has so far made it outperform EM peers, it may not remain so. A surge in outflow will test RBI’s stance. Foreign exchange reserves at $ 407 billion are sufficient to fund nine months’ imports and pay 24% of short term debt. But if fund flows don’t resume, RBI may have to sell another $20 billion from reserves to meet CAD, forecasts Bank of America Merrill Lynch economist Indranil Sengupta. At this stage, the India specific threat may be a lot lesser than what it was when it was in the club of ‘Fragile Five.’ But it still faces the contagion risk.