All emerging markets (EM), including India, are facing foreign portfolio investment outflows as the US Fed tightens. These sudden surges and stops, driven by changes in global risk, were a major reason emerging markets experienced weaker growth in the 2010s compared to the previous decade. The excess volatility of financial variables harms the real sector. The lesson for emerging market policy is to smooth volatility as much as possible.
Canonical inflation targeting wants exchange rates to float as the correct response to capital flows. Policy should react to exchange rate movements only after they have affected inflation or output. Any defense of the interest rate against the exchange rate would reduce the focus on inflation. But policymakers disagree because most emerging markets intervene in foreign exchange (FX) markets to reduce volatility. As Edward F Buffie and his co-authors point out in a 2018 paper, this is a serious problem for a theory whose position seems to be: And if floating doesn’t work in practice, it works in theory. Their research reveals that intervention in the foreign exchange market significantly improves the effectiveness of inflation targeting. Two instruments for two targets works better than trying to do it all through the interest rate. Excessive depreciation in thin markets can increase inflation. Markets can be trapped in cumulative one-way moves and panics.
Much other research, including from the IMF, argues for the use of prudential capital flow management techniques and finds that the accumulation of reserves and its use reduce risk and crises in emerging markets.
India has all these types of policies. Its sequential approach to capital account convertibility, where, for example, debt inflows are only allowed as a percentage of domestic markets, saved it from the kind of interest rate volatility that Indonesia has experienced. during crisis crisis and help now. Further liberalization measures can be taken if needed. The temporary relaxations announced on July 6 are an example of this. India’s large foreign exchange reserves have allowed the rupee to depreciate less than in most other countries as the dollar strengthens.
Yet inflation targeting purists are attacking the Reserve Bank for its intervention, not to mention the fact that India has achieved higher growth and lower inflation than most countries in these very difficult times. Never mind that it is dangerous to apply textbook economic theory based on perfect markets, regardless of time and place. These market purists, and those who would benefit from the additional business created, have long been pushing India towards full capital account convertibility. He would have been in big trouble if he had followed that advice. Capital flows are welcome, but as the internal market deepens, diversity increases but volatility is contained.
There are costs to holding large reserves and too much intervention. The central bank ends up supporting the United States and not its own government by borrowing and it sacrifices interest income. But holding reserves and not using them when needed is the most costly. Again, the use of multiple instruments can mitigate overuse of intervention.
Much recent research and experience suggests that all available instruments should be used to moderate the volatility of nominal variables. This would prevent excessive deviations of real variables, such as real interest and exchange rates, from equilibrium levels. These affect, and deviations can distort, actual industry decisions. During the previous decade, when Indian growth and investment rates had fallen, real interest rates ranged from 10 to 6 percent. While the depreciation benefits some exporters, all suffer from excessive exchange rate volatility.
The simplistic solutions proposed all lack this point of view. A common suggestion is to raise policy rates to maintain a historic differential with US Fed rates. But such interest rate defense did not prevent cash outflows during the taper tantrum or in 2018 and only triggered a downturn. He forgets that interest rate sensitive flows only represent about 8% of India’s external liabilities. Some of them are quite sticky. There were no debt outflows in 2022 despite a narrowing of the interest differential. Equity outflows also appear to be declining. Monetary tightening that dampens growth expectations induces more outflows as country risk premia increase. Some commentators assume that Indian inflation must rise with the United States and therefore want rates to rise. They forget that India has had no excessive fiscal stimulus and that its labor market is not tight. Its key rates must react to its own inflation.
Another group wants less intervention and more depreciation of the rupee in order to improve the current account deficit. But less intervention can lead to a chaotic fall and jittery markets as we saw in 2011. As inflation rises with nominal depreciation, real appreciation will result, derailing policy. It is the actual appreciation that affects the trade. It is preferable that the policy prevents excessive depreciation due to global risks. After a nominal depreciation of around 4%, India’s real effective exchange rate against a basket of 40 countries is approaching 100. This implies that the real exchange rate is too much depreciated since India has had relatively more structural reforms and productivity growth. Future corrections towards equilibrium will require a rise in the rupee. High oil prices pose a risk to India’s balance of payments, but several types of adjustments have the best chance of succeeding.
Market players want clear communication with no surprises for the markets. Forward guidance is an important element of inflation targeting. But when markets tend to overreact and are swayed more by US politics than Indian politics, the best way to introduce policy change may be a surprise. Thus, the markets had priced in excessive rate hikes after the start of Fed tightening in the United States. The surprise sharp rise in Indian repo rates prevented further rate hikes from being factored in as the domestic rate hike began. Yields have actually fallen now. The overnight index swap rate, which is overly influenced by foreign non-deliverable futures markets, forecast the repo rate to rise to 7.34% and has since fallen to a still excessive 6.77%. To forecast correctly, markets need to pay more attention to Indian conditions and internalize the inflation target. Inflation targeting and markets have yet to mature together.
Inflation targeting is an art that requires skill, attention to context and an open mind.
The author is a member, Monetary Policy Committee and Professor Emeritus, IGIDR.