COLOMBO : While presenting a paper on ‘Unconventional Monetary Policy and the Indian Economy’ in the SAARC Finance Governors’ Symposium at Colombo recently, Deepak Mohanty, Executive Director, Reserve Bank of India, underscored that in the recent global financial crisis most advanced nations’ central banks resorted to an unconventional monetary policy.
This policy included lending to financial institutions, targeted liquidity provisions for credit markets, outright purchases of public and private assets, purchase of government bonds and forward guidance. However, entry and exit from such policies have strong externalities and spillovers.
Mohanty highlighted the concerns of cross-border spillovers in view of prolonged recourse to unconventional monetary policy, particularly in emerging market economies (EMEs). This, he said was fully in evidence as the Fed communicated its intention of undertaking tapering earlier than anticipated which increased financial vulnerabilities across EMEs, though subsequent communication somewhat eased the pressure.
These policy developments, he argued, have significantly altered the external financial environment in many EMEs, including India. Given the complex interaction of global spillovers and domestic vulnerabilities, EMEs deployed a variety of policy measures.
While Indonesia and Turkey made greater use of their forex reserves to curb downward pressures in their currencies, others like South Africa used exchange rate as the main shock absorber. Many EMEs raised policy rates to curb capital reversals and to contain downward pressure on exchange rates (e.g., Turkey, Brazil, South Africa and India). Subsequently, greater clarity on tapering from the Fed coupled with domestic policy action helped EMEs gradually stabilise their markets.
Mohanty outlined some of the lessons from the process of tapering and its impact. First, the stance of monetary policy in advanced economies has spillover effects on EMEs. One of the key channels of transmission of vulnerability seems to be through accentuation of cyclicality in global capital flows. This is not to deny that relatively open capital accounts have their benefits but one has to be cognizant of risks which could arise essentially from exogenous events. Second, while spillover is unavoidable, domestic fundamentals are important to cushion its adverse impact, particularly for countries like India with greater external financing requirement. It is, therefore, desirable to contain the CAD around its sustainable level. Third, in the event of sudden capital outflow, as happened towards end-May 2013, domestic foreign exchange reserves become the first line of defence to contain volatility without resisting depreciation pressure. It is, however, difficult to say how much of reserves is adequate for the purpose.
Fourth, capital outflows reflect an imbalance in terms of surge in demand for foreign currency vis-à-vis domestic currency. Hence, the price of domestic currency needs to go up to provide some defence against capital outflows, though it may have adverse impact on growth. Accordingly, monetary tightening becomes a standard response. Fifth, in the event of a shock, external stability takes precedence over domestic objectives. In such situations, there is no single instrument to address the challenge.
Thus, drawing from the recent Indian experience, Mohanty emphasised that there is a need to use multiple instruments, including drawdown of foreign exchange reserves, monetary tightening, augmentation of reserves and administrative measures to dampen speculative outflows and encourage inflows to stabilise market conditions.
In the end once the pressure abates, it is important to reverse extraordinary measures to reinforce market confidence.