On 22 May 2013, Chairman Ben Bernanke first spoke of the possibility of the Fed tapering its security purchases. This and subsequent statements, collectively known as ‘tapering talk’, had a sharp negative impact on the emerging markets (Aizenman et al. 2014). India was among those hardest hit. Between 22 May 2013 and the end of August 2013, the rupee exchange rate depreciated, bond spreads increased, and stock markets declined sharply. The reaction was sufficiently pronounced for the press to warn that India might be heading toward a full-blown crisis that requires an emerging market to seek assistance from the IMF.
Why was India impacted so severely?
The impact was large for two reasons.
- First, India’s large and liquid financial markets had received significant volume of capital flows in prior years, making it a convenient target for investors seeking to rebalance away from emerging markets; and
- Second, its macroeconomic vulnerabilities had increased in the years prior to the tapering talk, making it susceptible to capital outflows and limiting the policy room to address the shock that the tapering talk initiated.
Eichengreen and Gupta (2014) analysed the impact of the Fed’s tapering talk on exchange rates, foreign reserves, and equity prices between May 2013 and August 2013. They found that an important determinant of the impact was the volume of capital inflows countries received in prior years and the size of their local financial markets. Those which received larger inflows of capital and which had larger and liquid markets experienced more pressure on their exchange rate, reserves, and equity prices once the tapering talk began. Evidently, investors are better able to rebalance their portfolios away from such countries. India ranks high in terms of the size and liquidity of its financial markets and the extent of capital flows it received in prior years, as shown in Figure 1.
Figure 1. Size and liquidity of the financial markets and the effect on the exchange rate during the tapering talk (India was among the largest and most liquid markets)
Source: Eichengreen and Gupta (2014)
In addition, emerging markets that had allowed their real exchange rates to appreciate and the current-account deficits to widen during the period of quantitative easing, saw larger impact. Similar vulnerabilities had built in India in prior years. Its current-account deficit had increased from about 1% of GDP in 2006 to nearly 5% in 2013; and its real exchange rate had appreciated markedly (Figure 2). Its fiscal deficit had increased, and inflation at about 10% was proving to be stubbornly high. These macroeconomic weaknesses had surfaced in the midst of a sharp growth slowdown. Although the level of foreign reserves was considered comfortable by some metrics, the effective coverage they provided had declined unmistakably since 2008.
The specific factors contributing to high fiscal or current-account deficit also indicated increased economic and financial vulnerabilities. The increase in budget deficit was due to an increase in current expenditure (in response to the Global Crisis of 2008, the headwinds of which were palpable in India by early 2009), than to a pickup in public investment. The increase in current-account deficit, largely a mirror effect of increased current expenditure, was characterised by some deflection of private savings into the import of gold. It reflected a dearth of attractive domestic outlets for personal savings in a high inflation environment, where real returns on many domestic financial investments had turned negative. Loose monetary policy in advanced countries meanwhile made those deficits easy to finance, further relieving the pressure to compress them.
Figure 2. Macroeconomic imbalances were evident in the Indian economy prior to the period of tapering talk
Sources: GDP, CSO; CPI Inflation, Citi Research; Gross Fiscal Deficit, Current-Account Deficit, Reserve Bank of India; Reserves to M2 Ratio, IFS; Real Effective Exchange Rate (CPI based, six currency), RBI; Bilateral RER calculated using data from IFS. Years refer to fiscal years.
The Policy Response
In response, the Indian authorities intervened in the foreign exchange market. They increased the overnight lending rate (the marginal standing facility rate) by 200 basis points to 10.25%. Gold imports – being partly responsible for a large current-account deficit – raised the import duty on gold from 6 to 15%. They opened a separate swap window for three public sector oil marketing companies to reduce exchange rate volatility, and imposed new measures to restrict capital outflows from residents. The latter included reducing the limit on the amounts that the residents could repatriate or invest abroad.1
We analyse the impact of these measures using event-study regressions. We compare the exchange rate five days after the announcement of the policy, with its value five days prior to the announcement. The results are summarised in Table 1 (shorter windows of 2 or 3 days yielded similar results).2
Table 1. Impact of policy announcements on exchange rate
Estimated % depreciation during the tapering talk, and before and after the policy announcement, compared to the tranquil period
||Increase in interest rate (15 July 2013)
||Liquidity facility to oil-importing companies (28 August 2014)
||Restrictions on capital outflows by Indian residents (14 August 2014)
||Import duty on gold (5 June 2013)
|During the tapering talk (from 22 May 2013 until a week prior to respective policy announcement)
|Before the policy announcement (a week before policy announcement)
|After the policy announcement (a week after policy announcement)
Note: Estimates are drawn from Basu et al. (2014). Percent depreciation in exchange rate are estimated using daily data for exchange rate with the regressions specification given by: Log exchange rate t = constant + µ Bond Yield in the USt + α Tapering Talk Dummyt + β Dummy for a week prior to Policy Announcementt + γ Dummy for a week after the Policy Announcementt + εt . Regressors include US bond yield to account for global liquidity conditions, dummy for the tapering period (from 23 May 2013-until a week before the policy announcement was made), dummy for one week prior to the policy announcement, and a dummy for one week after the policy announcement.
As is evident from Table 1, these measures were largely ineffective in stabilising the exchange rate. In particular, the Reserve Bank of India’s efforts to restrict capital outflows from residents and Indian companies had decidedly mixed effects. In the five days from the time when the announcement was made, exchange rate depreciation accelerated, and portfolio equity flows and equity prices declined. Subsequently, on 4 September 2013, upon formally joining the Reserve Bank, the new governor Raghuram Rajan issued a statement expressing confidence in the economy and highlighting the Bank’s comfortable foreign reserves position. In addition, he announced new measures to attract capital through deposits targeted at the Indian diaspora and relaxed partially the restrictions on outward investment that had been introduced previously. These new announcements and further guidance from the Federal Reserve Board, indicating more nuanced view of the tapering, helped calm the markets.
The way forward
India’s experience suggests that once a country is in the midst of a rebalancing episode, it can be difficult to counter the effects. It is better to put in place a medium-term policy framework that limits vulnerabilities, restricting the spillover impact in the first place, while maximising policy space.
Maintaining a sound fiscal balance, a sustainable current-account deficit, and an environment conducive to investment are integral to such a framework. Less obvious elements include managing capital flows to encourage relatively stable longer-term flows while discouraging volatile short-term flows, avoiding excessive appreciation of exchange rate through interventions using reserves and macroprudential policy, holding a larger stock of reserves, where feasible signing swap lines with other central banks, and preparing the banks and the corporates to handle greater exchange rate volatility. Finally, while implementing the medium-term framework and adopting any emergency crisis-management measures, countries need to adopt a clear communication strategy to interact smoothly and transparently with the market participants.
Aizenman J, M Binici and M Hutchinson (2014), “The transmission of Federal Reserve tapering news to emerging financial markets”, VoxEU.org, 4 April
Basu, K, B Eichengreen, and P Gupta (2014), “From Tapering to Tightening: The Impact of the Fed’s Exit on India”, Policy Research Working Paper, WPS7071, World Bank.
Eichengreen, B and P Gupta (2014), “Tapering talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets”, Policy Research Working Paper, WPS6754, World Bank.
 None of these policy measures were novel in the Indian context, having been implemented at different instances in the past, e.g. import duty on gold was prevalent until the early 1990s; deposits from the Indian diaspora were attracted in a similar fashion twice in the past, in 1998 and in 2000; and a separate swap window was made available to the oil importing companies in 2008 to reduce volatility in the foreign exchange market after the collapse of Lehman Brothers.
 See Basu et al. (2014) for details, as well as for results on the impact of policy announcements on equity prices, portfolio debt, and portfolio equity flows.